As the Federal Reserve watches economic developments in considering when best to raise rates, how financial markets respond will be just as important in determining the policy path, a top U.S. central bank official said Monday.
“How fast the normalization process will proceed depends mainly on two factors: how the economy evolves and how financial market conditions respond to movements in the federal funds rate,” said William Dudley, president of the Federal Reserve Bank of New York, speaking at the New Jersey Performing Arts Center in Newark, N.J.
While Mr. Dudley said he expects the Fed’s rate increases to follow a “shallow” path, he added that reaction in the short-term rates market could alter that process. If short-term rates stay low, the Fed may have to lift the policy rate more quickly to “exert some restraint on financial market conditions,” he said. If short-term rates respond by rising quickly, as they did during the “taper tantrum” in 2013, the Fed could slow down the rate-increase process, or even pause.
Mr. Dudley acknowledged that it’s unclear exactly how the eventual tightening will affect assets of portfolios and financial-market assets, but noted that investors’ portfolios are usually a mix of stocks and bonds and that a stronger economy can also provide support to equities.
For now, the official sees the policy rate’s longer-term resting place at around 3.5%, but admits there is plenty of uncertainty around his estimate.
The central banker wasn’t as focused on the exact timing of the initial rate rise, saying it hinges on how the U.S. economy evolves.
“The timing of normalization will be data dependent and remains uncertain because the future evolution of the economy cannot be fully anticipated,” he said.
Mr. Dudley said he sees the U.S. economy growing at a similar pace seen in the past two years, which would help bring the unemployment rate toward his estimate of full employment of 5% by the second half of the year from the current 5.5%. While he acknowledged March’s weak payrolls data reported last Friday and estimates the first quarter likely grew a disappointing 1%, the official said the weakness was likely caused in large part by temporary factor such as the harsh winter in the Northeast and Midwest.
The central banker holds a more optimistic outlook on the economy, saying the jobless rates is at a point where wages may start to increase and lend further support to the economy. He sees inflation firming later this year.
Even so, the official warns of two risks to his outlook: the stronger U.S. dollar and drop in oil prices. Mr. Dudley said his staff estimates the dollar’s 15% appreciation since mid-2014 will cut about 0.6 percentage point from gross domestic product this year. And while lower oil prices reduce the U.S. import bill, he worries about that weighing on investments in the U.S. growing energy industry.
“U.S. oil exploration-and-drilling activity is falling off very sharply. This will exert a meaningful drag on economic activity,” he said.
As for the mechanics behind the Fed’s rate increase after years of unprecedented easing, Mr. Dudley said the interest on excess reserves will serve as the main tool for the central bank to guide rates and that he’s “absolutely not worried” about the Fed’s ability to manage the process with its array of tools.
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