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