Fed's Dudley Makes Case for Rate Rises, Warns of Overheating Risks -- 2nd Update

Federal Reserve Bank of New York President William Dudley said Thursday the case for rate rises this year remains robust amid risks the economy could overheat, and warned that the new tax law could boost the U.S. deficit over time.

If the economy continues to make progress on achieving the Fed's job and inflation goals, "I will continue to advocate for gradually removing monetary policy accommodation," Mr. Dudley said in a speech given to a gathering of the Securities Industry and Financial Markets Association in New York.

The argument in favor of rate rises "remains strong," he said. Inflation that is short of the Fed's 2% target "argues for patience," he said, but added, "I think that is more than offset by an outlook of above-trend growth, driven by accommodative monetary policy and financial conditions, as well as an increasingly expansionary fiscal policy."

The central banker, who is set to retire this summer, also serves as vice chairman of the Fed's interest-rate-setting Federal Open Market Committee. Mr. Dudley was a consistent supporter of increasing short-term interest rates last year. The Fed delivered three increases in 2017, taking its overnight target rate range to between 1.25% and 1.5%, and it penciled in about three more increase for this year.

Officials are continuing to deal with weak levels of inflation that some central bankers believe argue against rate rises, even as the job market continues to perform strongly amid healthy economic growth.

Mr. Dudley said the Fed's collective expectation for three rate rises in 2018 "doesn't seem to be an unreasonable sort of starting point" for thinking about monetary policy. But what happens "depends on how the outlook evolves."

Mr. Dudley underscored in his speech that the economy could grow too quickly, which could drive the Fed to be more aggressive with interest-rate increases. At the same time, financial conditions haven't reflected the Fed's desire to boost the cost of borrowing.

"Financial conditions today are easier than when we started to remove monetary policy accommodation," Mr. Dudley said. This may mean the Fed "may have to press harder on the brakes at some point over the next few years. If that happens, the risk of a hard landing will increase," he said.

Mr. Dudley noted concern over the impact of the tax overhaul, whose Republican authors believe will unleash stronger economic growth and higher wages. Mr. Dudley warned that the tax law is likely to drive the deficit up over time.

"The current fiscal path is unsustainable," Mr. Dudley said. "In the long run, ignoring the budget math risks driving up longer-term interest rates, crowding out private-sector investment and diminishing the country's creditworthiness."

Near term, the tax bill may not even do all that much for the economy. "Most of the tax cuts accrue to the corporate sector and to higher-income households that have a relatively low marginal propensity to consume," Mr. Dudley said. "This suggests that a significant portion of the tax cuts will be saved, not spent."

Mr. Dudley was broadly upbeat about the economic outlook in the near term, however. He said his estimate of 2018 growth stood at 2.5% to 2.75%, and he expects today's 4.1% jobless rate to fall below 4% this year, which should in turn push up wages. He expects inflation to "drift" up to 2% over time.

Mr. Dudley shrugged off a recent narrowing in the difference between yields of short- and long-dated bonds that some see as a warning sign about the economic outlook. If this "flattening" of the yield curve wasn't happening, "it would suggest that we were behind the curve in removing accommodation," Mr. Dudley said.

The policy maker noted that he was "slightly but not particularly" worried by "elevated" asset-market levels. But he explained "even if financial asset prices were to decline significantly -- which presumably would occur if the economic outlook were to deteriorate -- I don't think such declines would have the destructive impact we saw a decade ago."

Write to Michael S. Derby at michael.derby@wsj.com

(END) Dow Jones Newswires

January 11, 2018 17:13 ET (22:13 GMT)