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REPEAT: Fed's Williams: Base Case Excludes Tax Proposal

Repeating Story Initially Sent At 13:00 GMT/08:00 ET
--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
     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
     "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
     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
     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
     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
     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:

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