San Francisco Federal Reserve President John Williams was the keynote speaker for the Sacramento Business Review this year. Dr. Williams spent about an hour outlining his view of the nation’s economic landscape and what it may all mean for the path of short-term interest rates over the coming years. In summary, short-term interest rates are likely to increase over the next two years.
The first factor that Dr. Williams focused on is the state of the employment markets. Unemployment is now below 5% which the Fed considers to be the “full-employment” level. In addition, there have been some signs that wages are increasing leading to concerns about wage inflation in coming months. If wage inflation takes hold without an offsetting increase in worker productivity, it could result in increased inflationary pressures that may push the national inflation rate above the Fed’s 2% target.
Second, commodity based inflation is coming back. After years of declining, oil prices bounced back in the first half of 2016. In October 2016 oil prices went from exerting deflationary pressures to inflationary pressures. This could lead to inflation of 2% or higher in early 2017. Should these inflationary pressures continue, the headline rate of inflation could exceed the Federal Reserve’s target.
Third, the Federal Reserve’s policy remains highly accommodative. Dr. Williams estimates that the neutral rate (the rate required to maintain full employment while keeping inflation at or below the Fed’s 2% target) is 2.75%. Currently, the Federal Funds Rate is set between 0.50% and 0.75%. Therefore, the Fed would need to raise interest rates by roughly 2% to reach its neutral policy rate.
Fourth, the Fed favors a slow and gradual path to raising interest rate in an effort to avoid spooking the the financial markets. Therefore, the Fed may need to continue to move interest rates up close to its estimated neutral rate, before inflation becomes a problem, to avoid having to raise interest rates too quickly in the future.
All of these factors point to several federal funds rate increases in 2017. However, Dr. Williams was careful to point out that the Fed is data dependent, meaning they will continue to assess new economic and financial data as it becomes available to guide their policy decisions.
During the question and answer session that followed Dr. Williams’ prepared remarks he was asked how changes in fiscal policy, specifically tax cuts or infrastructure spending, may change Fed policy. In accordance with the Fed’s policy to maintain its independence from other parts of the government Dr. Williams did not want to comment on fiscal policy, just as he would prefer politicians avoid commenting on monetary (interest rate) policy. However, he did note that each of the Fed’s governors attempt to incorporate the possible implications of fiscal policy
into their economic projections. Therefore, to the extent that fiscal policy could lead to higher rates of economic growth, employment and wage growth, and inflation, it could lead to a change in Fed policy. The takeaway from the meeting was that the Fed may be on track to increase short-term interest rates three to four times in 2017. Naturally, that was the same forecast that was prevalent this time last year and did not come to fruition, so it is understandable if investors are skeptical. However, the Fed seems to be making great efforts to communicate that they are serious this time. Therefore, the Fed may need to raise rates or face a further blow to its credibility.