Fed's Kaplan Sees 3 Rate Rises This Year, but Says More May Be Needed -- Update

Federal Reserve Bank of Dallas President Robert Kaplan said he expects the U.S. central bank will need to raise interest rates three times this year and perhaps even more to prevent a robust economy from overheating.

"The economy is going to be strong this year," Mr. Kaplan said in an interview Tuesday. He said he expects the unemployment rate to fall into the 3% range by the end of the year and for inflation to firm up after softening unexpectedly last year.

The stronger expansion, coupled with a burst of fiscal stimulus in the form of tax cuts approved last year in Washington, should support continued rate increases, he said. The Fed raised its benchmark short-term rate three times last year to a range between 1.25% and 1.5%, and it penciled in three quarter-percentage point moves for this year.

"I feel strongly and I have a lot of conviction that the base case should be three moves for this year, and if I'm wrong, it could even potentially be more than that," he said.

While the tax cuts didn't change his view about the number of times the Fed should raise rates, Mr. Kaplan said it did firm up his conviction about the need to move three times this year.

Mr. Kaplan also said it was important for policy makers to monitor financial-market reactions, including the tighter spread between short- and long-term yields on Treasury bonds.

The yield curve tends to flatten when the Fed raises interest rates, which pushes up two-year Treasury yields that are more directly affected by monetary policy than longer-term yields. While the 10-year Treasury has edged up over the past week, it remains historically low. When the yield curve inverts -- or when long-term yields fall below short-term yields -- a recession often has followed.

While Mr. Kaplan said an inverted yield curve was "worth worrying about, " he said he doesn't think the Fed's projected path of interest-rate increases was likely to lead to that. "We've got room to execute that base case," he said.

Moreover, the risks of an overheating economy and financial imbalances could rise if the unemployment rate fell far below the level most officials believe is sustainable over the long run. That level, projected at around 4.6%, is above the 4.1% unemployment rate reported by the Labor Department in December.

"The history of overshooting full employment has not been a happy one, and I believe the best opportunity for us to extend this expansion is to move gradually but deliberately to remove accommodation," said Mr. Kaplan.

Mr. Kaplan also signaled his unease over rising deficits and the direction of trade and immigration policy in Washington. Because individual tax cuts may do little to boost the supply of workers and the productive capacity of the economy, "my concern is that at the end of this three- or four-year period, we'll be approaching again trend growth, except we'll be more highly leveraged," he said.

The Dallas Fed leader said he was concerned policy wasn't doing more to address long-run challenges facing the economy, including demographic headwinds such as an aging workforce and slower growth in labor-force participation. Efforts to restrict legal immigration are "not conducive to higher [gross domestic product] growth," he added.

Mr. Kaplan said he was concerned the U.S. economy would suffer if it withdrew from the North American Free Trade Agreement because the U.S. would surrender its position to compete against European and Asian nations by breaking apart supply chains with Mexico that have conferred significant competitive advantages.

He said he was worried that a breakdown in U.S.-Mexico relations could influence this year's Mexican elections.

"The United States is very well served by having a constructive relationship with neighbors on its border," he said. "I'm concerned that...we might create an environment with the rhetoric that you can't get elected unless you are a little bit antagonistic to the United States."

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

January 17, 2018 13:10 ET (18:10 GMT)