MNI EXCLUSIVE: Fed's Williams: Base Case Excludes Tax Proposal

--Fed Well-Positioned Regardless Whether Major Fiscal Policy Enacted

--3 Rate Increases in 2018 Puts Fed in Most Balanced Position

--Sees Infl Rising With Tight Labor Market Starting Spring 2018

By Jean Yung

     SAN FRANCISCO (MNI) - Federal Reserve Bank of San Francisco President John

Williams believes the Fed is well positioned to manage the economy regardless of

the outcome of the tax reform being debated on Capitol Hill, but sees a soft

landing from monetary accommodation as the major challenge facing the U.S.

central bank, MNI learned in an exclusive interview.

     Williams told MNI Friday he feels comfortable with letting the economy run

a very strong labor market to help get inflation back up to 2% over the next

year or two, though taking such a path is not without risk. Keeping imbalances

at bay as the expansion continues will be a "major challenge," he cautioned. 

     Given the current state of the economy, the Fed should aim to raise

interest rates in December and three more times next year to put itself in the

best position to respond to a range of contingencies, from a major fiscal

stimulus to stubbornly low inflation or any other number of economic curveballs,

said the San Francisco Fed chief, who holds a vote on the rate-setting Federal

Open Market Committee in 2018.

     "Everyone talks about when you're in monetary policy, you want a soft

landing. Well, we know from experience that's a lot harder to do, to keep that

expansion going without getting the economy out of balance. And I think that's

going to be a major challenge," he said. 

     Even with the U.S. economy about "as strong as I've seen in my professional

career" and solid and resilient growth overseas, inflation is "running well

below desirable levels," Williams said. 

     "The challenge for us right now is really the issue of low inflation," he

said.

     The personal consumption expenditures price index, the Fed's preferred

inflation gauge, peaked at 2.2% in February before falling to 1.6% in September.

Core PCE inflation slid from 1.9% to 1.3% over the same period. 

     One potential upside risk to the economy is the tax bill the House

Republican leadership unveiled last week, a first step toward passing

comprehensive tax reform. Budget analysts have said the bill could add $1.5

trillion to the deficit over 10 years.

     But Williams said his current base case does not include a major fiscal

policy initiative and he's "not losing sleep" over whether tax cuts or

infrastructure funding bills are passed.  

     "I don't need to come to a conclusion today or at our next meeting ...

about what our fiscal policy will be next year in order to have a pretty clear

view of what we should be doing now," he said. 

     Monetary policy is "well positioned" to respond to the economic impacts of

tax reform, Williams said. But with $20 trillion in national debt and a plan to

phase in the cuts over a number of years, a proper analysis of the net effects

will need to include a careful examination of whether the overhaul can growth

the supply side of the economy. 

     Without a boost to productivity or labor force participation, a fiscal

stimulus will have modest effects on economic growth over the long run, Williams

said. Of the major drivers of productivity growth -- improved quality human

capital, research and innovation, and business fixed investment -- the current

proposal focuses solely on the last factor while sacrificing research and

development tax credits and without providing new funding for education, he

said. 

     "Our current tax system has a lot of flaws in it. It's outdated. So I'm not

trying to argue if the reforms are good or bad. We just have to be realistic

about longer run productivity." 

     Addressing recent weakness in inflation, Williams cited research by his

staff showing that nontransitory factors were playing a role in holding down

prices. 

     In addition to permanent adjustments in the cost of wireless service plans

in the spring, a drop in health care charges driven by Affordable Care

Act-mandated price revisions has spilled over to the private sector and its

effects are likely to continue to be felt into next year, he said. 

     "I think of these as supply shocks that are holding inflation down that

really aren't cyclical," he said, meaning they aren't driven by the strength or

weakness of the economy. 

     "We need to have a pretty strong economy, a tight labor market in order to

create a little bit more inflation in more typically cyclical parts of the

inflation rate" to make up for that shortfall, he said. 

     To help accomplish that, the Fed should hold policy somewhat accommodative.

With unemployment well below his view of its natural rate, Williams said he

expects it to "continue to come down and drop below 4% early next year and stay

there for some time." 

     As for why inflationary pressures have yet to surface, despite the

unemployment rate sinking to its lowest level since 2001, Williams counseled

patience. Empirical evidence suggests there's about a one-year lag before the

effect of a fall in unemployment below its longer run level hits the inflation

rate. 

     It wasn't until early 2017 that the unemployment rate fell on a sustained

basis below the FOMC's median estimate of its natural rate of 4.6%, which means

that "until early this year, we still were running a labor market that was

either having slack in it or kind of neutral. It was only in the last few months

that we've arguable been in a market that's getting tight," Williams said. 

     "Assuming my forecast comes true and unemployment goes from 4.1% to 3.9%

and 3.8% and stays there, then that will accumulate in terms of its effect and

put more upward pressure on inflation next year and in 2019," he said. 

     The same reasoning applies as to why wages haven't risen as quickly as

hoped, he added. "But the effects really should be showing up over the next year

or year after."  

     Looking further into the future, as inflation rises, the Fed must reverse

its stimulus to "keep the economy from getting out of whack with fundamentals,"

Williams said.

     Job growth numbers will need to slow from its current pace of about 165,000

a month to a breakeven rate of 80,000 to 100,000 per month needed to absorb new

labor market entrants, and the unemployment rate needs to move back up to around

4.6%, Williams said.    

     "But that's in the future," he said. "The first thing we need to do is to

keep things going the way they are and get inflation pressures up a bit." 

     His views are generally in line with those of Fed Chair Janet Yellen, who

in September said the Fed needs to continue gradual rate hikes despite

uncertainty over the path of inflation. Yellen said at the time that it is

possible that the FOMC may have misjudged "even the fundamental forces driving

inflation." 

     Williams employed a tennis analogy to describe the Fed's stance: "I think

we're standing in the middle of the court. We're able to move left or right

depending on how the data evolves, and what kind of tax policy there will be." 

     What worries him more deeply, he said, is whether fiscal and monetary

policymakers will be prepared for the next recession. 

     With budget analysts predicting the GOP's tax plan will create much larger

deficits and add to the national debt, one likely consequence is less scope to

run deficits in response to a severe recession, Williams said. 

     "One of the side benefits, if we have the fiscal house in order over the

long run, is it does give more room to maneuver in case of an economic downturn

or crisis," he said. 

     Without it, another tool in the crisis toolbox goes missing that could

potentially prevent a bad situation from spiraling to panic or fear, Williams

said. 

     As for the FOMC, it has learned a great deal about using unconventional

policy tools during the Great Recession and "how to move more quickly to use

them," Williams said. 

     Both forward guidance and bond purchases have proven to be very powerful

medicine when rates are near zero, he said, while the possibility of having

"somewhat negative interest rates" is one that should not be excluded either,

given it has proven to be supportive of growth in the currency blocs that have

deployed it. 

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

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