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FOMC Vice Chairman: Fed Should Hold Off on Rate Hike

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Just as subtle changes like rearranging chairs or removing a portrait gave birth to Kremlinology, the art of determining Soviet policy through the intensive search for clues, so too do market observers comb through the nuances of Federal Reserve lingo in hopes of ascertaining the future of monetary policy.

That may be especially important after Chairwoman Janet Yellen’s Capitol Hill testimony earlier this week, which generated contrasting headlines, with some reporters hearing a hawkish stance and others a dovish one.

Possible clues into Fed thinking can be found at the 2015 U.S. Monetary Policy Forum, held Friday in New York, where William Dudley, presedent of the Federal Reserve Bank of New York, gave a highly technical talk with decidedly dovish tendencies.

While Dudley was explicit in stating that the views he was expressing were his own, the New York Fed president also serves as vice chairman of the policy-setting Federal Open Market Committee, a position of obvious influence.

The need for professional “Fedology” was apparent in a talk focusing on the “equilibrium real federal funds rate,” and liberally sprinkled with terms such as “Taylor-type rule,” “non-stationary” and “inertial policy rule.”

But the upshot, that Dudley is an advocate for caution with respect to raising rates within internal Fed policy meetings, seems unmistakable.

The New York Fed president’s remarks were an extended commentary on a technical paper about what federal funds rate is implied by financial market conditions.

Dudley said he was in broad agreement with the paper’s five conclusions — that several factors such as GDP growth, risk aversion, bubbles and busts and regulation influence short-term rates; that there is insufficient evidence to assume the persistence of zero-bound rates; that short-term rates won’t necessarily revert to some long-run average; that the integration of global markets will force short-term rates here and abroad to move in tandem; and that short-term rates should be allowed to rise only slowly amidst profound uncertainty.

Dudley explains how he arrives at his cautious policy approach by focusing on three questions. The first involves the technical question of how real potential GDP growth affects real short-term interest rates. The FOMC member regards the relationship as “very loose,” and suggests breaking down GDP growth to smaller constituents such as labor force growth and productivity growth.

A rapidly growing work force — as the U.S. experienced in the 1970s as baby boomers began their careers and women’s labor force participation surged — implies rising short-term rates. So too does rising productivity, as people bid up capital, as the late ’90s tech boom demonstrated.

But today’s environment implies quite the opposite, as Dudley explained in a key comment:

“If the growth in labor input and productivity were positively related with the equilibrium real short-term rate, then in the current environment this would be consistent with a relatively low [rate].”

In other words, Dudley is disturbed by the less than 0.5% annual rate of labor force growth over the past five years, and 1% to 1.5% annual average productivity growth in recent years.

The other key question he asks — perhaps the most important question for “Fedologists” — involves how quickly policymakers should act in normalizing rates. And his answer is not very.

While part of his explanation is technical, involving the earlier adduced Taylor Rule, Dudley is clear as a bell in his statement that “I believe that the risks of lifting the federal funds rate off of the zero lower bound a bit early are higher than the risks of lifting off a bit late.”

The New York Fed president cites “lingering headwinds related to the financial crisis” and projections that inflation is expected to persist below the Fed’s 2% target for some time. He notably adds that his view about the pace of raising short-term rates would materially change if inflation expectations moved north of the 2% target.

A third key question Dudley addresses involves the influence of financial market conditions on rates. He notes that the “1-year forward rate, 9 years ahead” has dramatically fallen from around 5% in December 2013 to just under 3% currently. Dudley concludes that in today’s highly globalized markets, low yields in Europe and Japan have pulled down U.S. rates.

This globalization trend is one factor adding policy uncertainty, for which reason Dudley rejects the so-called Taylor rule, with its formulaic approach to policy rates based on economic conditions. That said, were the market to continue to compress rates even after the Fed began raising short-term rates, that would signal to Dudley the need for “a more aggressive path of monetary policy normalization.”

Beyond all the nuance and one-hand, other-hand type analysis, Dudley’s bottom line view for now is that the GDP growth will be relatively lower over the medium term (because of the low work force and productivity growth rates he previously cited), implying a long-term federal funds rate of 3.5%.

But Fedologists take note:

“I…have little confidence about the accuracy of this specific estimate,” he said.

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