John Williams Easing Us into Normalization

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The President of the Federal Reserve Bank of San Francisco, John Williams, gave a presentation on March 5th about the outlook for monetary policy.

He basically is easing our understanding towards accepting the rationale for normalizing (raising) nominal interest rates. I personally am in agreement with what he says and how he says it. He is making the case that the Federal Reserve needs to start raising the Fed rate soon so as not to raise it more drastically later.

He is not worried about low inflation. He is not worried about low wage inflation. He recognizes that the unemployment rate is getting close to his projection of 5.2% as the full employment rate in the NAIRU sense. He anticipates wage inflation by 2016 and wants to be proactive in responding.

In his presentation, he refers to others, like Paul Krugman, who would rather see inflation return to target before raising rates.

“Not everyone agrees, of course. There are a number of people who think we should wait until inflation is very close to, or has crossed, the finish line. They’re mainly worried that raising rates too soon would allow inflation to fall further and possibly derail the recovery.”

His best response to them is…

“Monetary policy, as Milton Friedman famously reminded us, has long and variable lags (Friedman 1961). As I said, it usually takes a year or two for policy to have its full effect. As a result, policy must be forward-looking. When you’re driving towards a stoplight, you don’t keep your foot on the accelerator; you ease off so you’re ready to stop at your target. Otherwise you slam on the brakes—and probably wind up in the middle of the intersection.”

John Williams seems to be sensible in his projections. I agree with him that a slight rate hike in mid-2015 would not derail the economy. Of course, there will be some stress on the economy as rates tighten, but that stress is designed to balance vulnerabilities in the economy.

Moreover, how fast will the Fed rate rise after the first rate hike? That is the interesting question. How will the data respond to the first rate hike in the short-run considering that Williams says that the effects of monetary policy have a lag of 1 to 2 years? How will the Fed respond to incomplete data responses in the short-run?

John Williams is basically saying… Take it easy folks, a slight rate hike is a safe and sensible step toward the needed normalization of monetary policy.