Fed's Williams: Rates Need To Rise Toward 2.5% Neutral Rate

--Structural Changes Depress Economy's Speed Limit; Longer Run Real GDP Growth

1.5%

--Optimistic Inflation Will Rise to 2% Goal Over Next Couple Years

--Change in Health Care System, Other Temporary Factors Holding Down Inflation

By Jean Yung

     WASHINGTON (MNI) - The Federal Reserve needs to move ahead on gradually

lifting interest rates back to more normal levels, but the "new normal" for

rates is closer to 2.5% amid a sharp decline in labor force growth and slower

productivity gains, San Francisco Fed President John Williams said Thursday.

     The U.S. economy continues to expand at a moderate pace while the labor

market has already exceeded full employment, he said. While inflation has been

weaker than expected, there reasons to believe that the factors holding down

inflation are temporary, Williams, who votes on rates next year, said. 

     "These favorable employment numbers, combined with the findings on

inflation and the steady pace of growth, are all behind my confidence that rates

will need to rise to their new normal levels" of around 2.5%, Williams said in

remarks prepared for a community banking conference at the St. Louis Fed Bank.  

     He was "optimistic that inflation will move up to our 2 percent goal over

the next couple of years," despite core inflation falling back to 1.3% after

hitting 1.9% earlier in the year. 

     Researchers at the San Francisco Fed found that mandated cuts to Medicare

payment growth have kept inflation in overall health care services unusually low

for several years and have been "a key factor holding inflation below the Fed's

2 percent target, despite a strengthening economy," Williams said. 

     Inflation rates for categories that tend to be less sensitive to movements

in the economy had also "fallen a lot and have remained very low," including

some "outsize drops" in prices for pharmaceuticals, airline tickets, cell phone

services and education. 

     "In the past, such sharp price movements in these industries have proven to

have a temporary effect on inflation, and I don't expect them to last this time

either," Williams said. 

     Meanwhile, unemployment has fallen to 4.4%, below that of his estimate for

its natural rate of 4.75%, and will likely continue to fall below 4% over the

next year, Williams said. "We've not only reached the full employment mark,

we've exceeded it," he said.

     Even so, "conventional monetary policy has less room to stimulate the

economy during an economic downturn" now than in previous decades, he said. 

     The foundation of William's analysis is his belief that the natural rate of

interest, so-called r-star, has fallen in an economy with a slower sustainable

pace of growth. It's around 0.5% today, a full 2 percentage points below what a

normal interest rate looked like 20 years ago, Williams said. 

     Its level is formed by "structural economic factors beyond the influence of

central banks and monetary policy," and that declining trend is not limited to

the United States. Average r-star across Canada, the euro area, Japan, and the

United Kingdom is a bit below 0.5%, he said.

     One major factor driving the decline in r-star is that the sustainable

growth rate of the economy has slowed dramatically from prior decades to about

1.5% real GDP growth, "the slowest pace we've seen in our lifetimes," Williams

said. 

     This slowdown reflects a sharp decline in labor force growth and slower

productivity growth, factors that are not likely to change. 

     However, "The new normal is likely to be 2.5 percent, and banks, and

everyone else, need to prepare accordingly," Williams said. 

     Faced with a future economic downturn, the Fed will "need to lean more

heavily on unconventional tools, like central bank balance sheets, keeping

interest rates very low for a long time, and potentially even negative policy

rates," he said. 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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