Fed's Daly sees inflation reaching 2% goal next year

SAN RAMON, Calif. (Reuters) - U.S. inflation, which has fallen short of the Federal Reserve’s 2% goal for years, should reach that benchmark next year, pushed by a tight labor market and rising wages, San Francisco Federal Reserve Bank President Mary Daly said on Wednesday.

FILE PHOTO: San Francisco Federal Reserve Bank chief of research Mary Daly stands near the podium before a speech at the CFA Society in San Francisco, California, U.S. July 10 2018. REUTERS/Ann Saphir/File Photo

“My expectation is inflation will gradually go back up to target and reach a sustainable 2% in 2021,” Daly said at the Bishop Ranch Executive Forum in San Ramon, about an hour’s drive from San Francisco.

The Fed’s three rate cuts last year put the U.S. economy on track to grow this year by 2%, slower than last year but still fast enough to keep unemployment near its current 3.5% level and to push up wages by between 3% and 3.5%. “If it went up a little bit more, that would only get us to our inflation target a little bit faster,” Daly said.

Most Fed policymakers expect to leave interest rates where they are for the foreseeable future, confident as Daly is that a tight labor market and solid economic growth will be enough to overcome factors that have long kept inflation subdued, including downward pressures from abroad. Currently U.S. inflation by the Fed’s preferred gauge is about 1.7%.

Whether the Fed’s target range for the policy rate, between 1.5% and 1.75%, really is low enough to foster a return to what it sees as a healthier level of inflation is sure to be a central topic of debate this year among Daly and her colleagues.

Daly also addressed a second big topic for the Fed as this year starts: how to avoid any unexpected spikes in short-term funding costs like that which roiled markets last September and caused the Fed to briefly lose control of its policy rate.

The Fed, which had been shrinking its $4 trillion portfolio of securities to find what Daly called “the lowest possible efficiently run balance sheet” that would still give it control over its policy rate, did a swift about face in response to the spike.

By injecting billions of dollars into the so-called repo market that banks tap for cash lending, and buying $60 billion a month in U.S. Treasury bills to expand its balance sheet, the Fed has since smoothed markets.

The problem, Daly explained, was the Fed had underestimated the liquidity that banks would need, partly because banks themselves had underestimated their own needs and had given the Fed projections that turned out to be too low.

Regulations that big banks meet an “intraday” liquidity threshold may have also prompted banks to hold on to more cash than the Fed had expected, she said.

“We learned about the regulation issues, married with the way businesses want to run, and so we are still thinking about those types of things,” Daly said. “But the most important thing is, we have a plan in place to keep ... the funds rate trading in its range.”

Reporting by Ann Saphir; Editing by Chizu Nomiyama