Danny Moloshok/Reuters John Williams, president of the San Francisco Fed. John Williams, president of the Federal Reserve Bank of San Francisco, is feeling pretty good about the economy. He is ready to continue the Fed’s retreat from bond-buying and forward guidance. And he says he’s optimistic that this time, the Fed will manage to produce a soft landing. The transcript of our conversation earlier this week has been lightly edited for clarity.
Q.I assume the February jobs report only strengthened your conviction that the economy is improving, and that the Fed should continue to pull back.
A.Definitely the jobs report was on net a positive piece of information. I think it provided a little more clarity that the weather effects were part of the story and obviously the number was reasonably good and the revisions were positive. It’s always important to take a longer-term perspective but my perspective is that the economy is on a good growth trajectory with good momentum. I expect 2.5 to 3 percent growth this year. I think trend is only about 2 percent right now so I expect the unemployment rate to keep coming down this year and next year. We’ve continued to make good progress and my own view is that the data have not in any way moved against the basic contours of the forecast. My own view would be to continue the tapering at the pace that we’ve been doing.
Q.So we would have seen more job creation with warmer weather?
A.It’s pretty clear that the report would have been even better without the effects of the unusual weather. So looking ahead you would expect a report that’s even stronger in the next month because of the bounce-back.
Q.How much slack remains in the labor market? Specifically, how much of the decline in labor force participation will reverse if the economy keeps growing?
A.Maybe half of the decline is not explained by retirements. When we do the analysis we try to look at how much is explained by disability, and â€" I hate the phrase “prime age males†as I get closer and closer to the end of that - but how much is people who might return to the labor force. Maybe a third of the decline since 2007 is maybe more cyclical in nature and we expect that to come back.
Q.What indicators do you watch to judge if you’re wrong about the extent of slack?
A.What I try to look for is a coherence across all of these different kinds of metrics. We take them all together and we create a kind of a database that has all of these and look for the central tendency of all of those and then try to understand why certain outliers are behaving differently. For example, why are there so many vacancies out there according to JOLTS when the job market appears to be relatively weak? Are firms listing many jobs but only hiring perfect candidates?
Q.How closely are you watching compensation data to judge slack?
A.Wages tend to lag a bit so they’re not really a great leading indicator of tightness in labor markets and in fact if anything there’s a tendency for wage growth or compensation growth to remain somewhat subdued and then to really pick up later in the cycle. So I wouldn’t want to wait around to see compensation growth pick up a lot to see that the economy is getting closer to full employment.
Some economists see evidence that inflation is tied to short-term unemployment. Right now we have a lot of long-term unemployment and a lot of people who have stopped looking for work. That suggests you could start to see wage and price pressures before the economy has returned to full employment.
If there is some kind of short-run trade-off, we’ve been studying in the S.F. Fed what are the monetary policy implications, studying how does one balance those trade-offs. We’re not talking about trade-offs in the long run. We’re only talking about trade-offs in the short run. This is in many ways kind of like a temporary supply shock to the economy. It means inflation goes up higher than you would expect given the utilization of resources. And we know how monetary policy should respond to supply shocks. You balance the two. You let inflation rise for a little bit but not too far. If you have to create a little bit of inflation above your target for a little while that’s exactly what monetary policy should do.
In a recent interview with The Financial Times, you appeared to express misgivings about exactly this kind of overshooting.
A.My more general point on not wanting to overshoot: It’s not that you should never allow inflation to be above the target. My earlier comment is more in the context of, we can’t keep the pedal on the metal all the way down until we’re at full employment. You actually have to adjust monetary policy before you get to the point where you reached your goals.
There’s a further argument that the Fed could face a similar trade-off between tolerating higher inflation and seeking to increase labor force participation. The idea is that the Fed would need to continue its stimulus campaign after the unemployment rate has normalized to draw people back into the work force.
If you knew there were people who have dropped out of the labor force but were effectively wanting to work then I would count those people as being part of the labor market slack. If you had confidence that that were true then that would call for easier monetary policy. It’s another layer beyond long-term unemployment. The hard part of that is, we don’t really know what percentage of people who dropped out of the labor force really are ready to come back into the labor force and how many are just permanently out of the labor force. As time goes on I think we’ll have the empirical test of the hypothesis. As employment gets better and as the economy gets better we should start seeing if that dynamic takes hold and I hope it does. And if the evidence is really strong then I think that will be part of the analysis.
Is the cost of too much caution the permanent loss of some people from the work force? Do the losses begin to calcify if the Fed doesn’t go far enough?
A.I agree with disability, that that’s an issue. But more generally I’m still of the view that based on the analysis we’ve done that if we can keep this economy growing significantly above trend and see those improvements, I don’t expect there to be those truly permanent large losses. I’m of the view that the long-term unemployed, as the labor market gets hotter and hotter, companies are going to start hiring them again and people who’ve been out of the labor force will come back.
Q.You have advocated replacing the Fed’s current guidance on interest rates, which is linked to a specific unemployment rate, with a less specific description of objectives. Isn’t that necessarily a less effective kind of guidance?
A.Back in 2011 the qualitative guidance wasn’t strong enough and so we went to the data-based concrete guidance and I thought that whole period was very successful. We had a disconnect between our views of where the policy was going and what the market thought. We used some pretty strong language saying what our intentions were and that seemed to work pretty well. I think that was really helpful and in many ways successful. As we’ve gotten away from truly extraordinary times and we’re in a transition toward somewhat more normal times, then the argument for trying to put out this really strong signal about, ‘We’re not going to raise interest rates until we see this one thing happen or this other thing happen,’ I don’t think is the right approach because it puts way too much attention on one aspect of the data. My preference would be to see us moving to describing our policies in our statements much more consistently and clearly. Here are our objectives, here’s where weare relative to them, and given this progress that we’ve made, here’s the policy stance we’re taking and here’s how we’re going to adjust this going forward. If that’s more the approach we’re going to take it would be vaguer or more general than a number. But I think it would be more accurate.
Q.Are you worried about losing control of market perceptions?
A.I am concerned that market participants do need guidance regarding our policy plans. It’s not easy to look at what we’ve done over the last five years and figure out what we intend to do about the short-term interest rate. How to do that without going to dates and using numbers, that will be the art of crafting how we communicate. We can’t just rely on the F.O.M.C. statement on its own to explain our policy. [Janet Yellen] will have opportunities to explain in testimony and speeches. We also have the economic projections and those can be used more effectively to convey views about a forecast for the economy and what appropriate policy looks like. I recognize that this is an issue and it will be important from now until we actually raise rates to make sure we’re not allowing market expectations to drift.
Q.Does the current level of inflation make sense to you?
A.If you had put me in a spaceship for five years and then I’d just come back to earth, this would be the first time in five years that I would think it made sense. It surprised me that it didn’t fall more during the recession, then it surprised me that it bounced back as much as it did, and now it’s fallen back. A lot of people have said, look how much it’s fallen, but it’s really more that it popped up more than we expected, and now it’s fallen back a bit more. So probably I think it does kind of make sense where it is right now. The test of this is going to be this year and next. As the labor market improves, I am expecting inflation to drift back up toward 1.5 and 2 percent over the next few years. If inflation stays around 1 percent then there’s something else going on and clearly we’ll have to re-examine that.
Q.Do you see signs the Fed’s policies are destabilizing financial markets?
A.If you compare it to the housing market bubble and the stock market bubble, those were pretty obvious to anybody with a computer screen. When you look at 2004-5 in the housing market, those were screaming breakdowns in historical relationships. To my mind the thing that you worry about is, even if you don’t see anything obvious, you want to always be asking questions, given that interest rates have been so low for so long, Where could those risks start to emerge? What kind of policies could we be taking to try to mitigate those risks to the system?
I’m not arguing that we need to be doing that today but this is a great time to be really focused on what tools do we have available? I feel our discussion, the discussion is too much about what should monetary policy do about this when I really think that monetary policy is part of it, but we really should be figuring what can we do about this and monetary policy should be more of a last resort.
Q.You’ve said several times during our conversation that we’re returning to normalcy. A lot of people are uneasy about the Fed’s ability to manage that return.
A.I think we’ve got significant challenges ahead of us that are far greater than normal periods of monetary policy. Not only the communication around the taper but more generally that whole exit period of moving from zero interest rates after many, many years, and what happens to our balance sheet, these are clearly big issues that are ahead of us and getting the soft landing right is very difficult.
Q.But the Fed almost never lands softly.
A.Maybe this will be the one time we have a soft landing. We haven’t had a lot of breaks in the last few years.
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