The Federal Reserve should start raising interest rates next year, a top Fed official said on Monday, arguing that even if rates stay near zero for many years, U.S. economic output will not bounce back to pre-recession levels.
Last month the Fed said it was likely to keep interest rates exceptionally low through late 2014 to bolster a recovery that was moving too slowly.
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St. Louis Fed President James Bullard said he disagreed with that decision, arguing that the housing collapse means unemployment is likely to stay high and labor markets will improve only slowly even if rates are kept low for many years.
Bullard, who does not have a vote on the Fed's policy-setting Federal Open Market Committee this year, is seen as a policy centrist.
"It's important to start to remove accommodation - even when you go up to 1 percent or 1-1/2 percent, that's still very easy monetary policy," Bullard told reporters. "It's a matter of getting to a normal level of interest rates at the right time. I don't think you want to wait until everything is exactly the way you'd expect it to be."
Fed Chairman Ben Bernanke last month left the door open to new bond purchases to boost growth, a move that Bullard said he would support only if the economy worsened further and the threat of deflation re-emerged.
The Fed cut rates to near zero more than three years ago and has bought $2.3 trillion worth of bonds to spur economic activity.
Keeping rates low for three more years could do more harm than good, Bullard said, because the U.S. economy is not suffering from an "output gap" that can be bridged only if borrowing costs are kept low enough for long enough, but from a permanent shock to household wealth due to the sharp drop in housing prices.
"The large output gap view may be keeping us all prisoner - tethering our expectations for output, in effect, to the collapsed bubble in housing," Bullard said. "A near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth."
The U.S. economy is on track to grow at a 3 percent rate this year and to strengthen further next year, Bullard said. That should help push the unemployment rate below 8 percent by the end of this year, he projected. It registered 8.3 percent in January, and most Fed officials last month saw the rate staying above 8 percent through this year.
Meanwhile, inflation, while falling, is running above the Fed's newly set target of 2 percent.
The idea that an output gap is keeping inflation at bay and that super-easy monetary policy can push production back to pre-recession output levels is wrong, Bullard said.
"If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates," he said. "This could be a looming disaster for the United States."
Bullard said keeping rates low for several quarters is very different from keeping them there for years, which punishes savers. Younger generations hurt by high unemployment are not increasing their consumption to make up for the decline in consumption among older generations, he said.
"In this sense, the policy could be counterproductive," he said.
Bullard said he welcomed the Fed's adoption of an explicit inflation target because it may keep the central bank from allowing higher inflation in pursuit of bridging an illusionary output gap.
"This is an important development, as it may prevent the U.S. from repeating the mistakes of the 1970s, in which a misreading of the size of the output gap led the Fed to maintain easy monetary policies for far too long," he said.