February 27, 2015 / 3:17 PM / 3 years ago

Dudley, top U.S. economists urge later Fed rate hike

NEW YORK (Reuters) - Raising interest rates too late is safer than acting too early, an influential Federal Reserve official said on Friday, endorsing a high-profile research paper that argues that the U.S. economy, given time, can rebound to normal growth.

William Dudley, President of the New York Federal Reserve Bank, speaks at Brooklyn College in the Brooklyn borough of New York, March 7, 2014. REUTERS/Keith Bedford

The paper by four top U.S. economists, presented on Friday to a roomful of powerful central bankers in New York, argues the Fed would be wise to keep rates at rock bottom for longer than planned and then tighten monetary policy more aggressively.

New York Fed President William Dudley, who offered a critique of the paper, cited currently low inflation and warned against being too anxious to tighten monetary policy.

The risks of hiking rates “a bit early are higher than the risks of lifting off a bit late,” he told a forum hosted by the University of Chicago’s Booth School of Business. “This argues for a more inertial approach to policy.”

The U.S. central bank is in the global spotlight as it weighs when to lift rates after more than six years near zero, and how quickly to tighten policy thereafter, given the economy appears to have finally recovered from recession.

Some policymakers, like Cleveland Fed President Loretta Mester, caution against waiting too long, given concerns about potential financial stability and an erosion of public confidence in the economy.

But the paper’s authors, like Dudley, offer a somewhat dovish solution to the dilemma.

They conclude that the Fed cannot be certain to what level it should aim to ultimately raise its key rate. But this equilibrium level, they say, has not fallen as low as claimed by those who warn of a “secular stagnation” in the United States.

Given the uncertainty, “there may be benefits to waiting to raise the nominal rate until we actually see some evidence of labor market pressure and increases in inflation,” wrote the economists, including Jan Hatzius of Goldman Sachs and Ethan Harris of Bank of America Merrill Lynch.

They suggest a “later but steeper normalization path” for rate rises than the Fed’s own predictions, which imply the first hike around mid-2015 followed by more. Under median forecasts for Fed policymakers, the fed funds rate would hit about 1 percent by year end and 2.5 percent a year later.

Fed Chair Janet Yellen said on Wednesday “we don’t yet know what the new normal is” in terms of growth.

But the paper offered an optimistic defense of U.S. resilience in the face of a growing chorus of pessimists, including former Treasury Secretary Lawrence Summers, who have argued that persistently weak demand for capital means Americans need to get used to a less muscular economy.

The authors wrote in their 80-page paper that this secular stagnation theory is “unpersuasive,” arguing temporary factors like household savings and fiscal tightening made the recovery from recession slower than expected.

Cleveland Federal Reserve President and CEO Loretta Mester gives her keynote address at the 2014 Financial Stability Conference in Washington December 5, 2014. REUTERS/Gary Cameron

Mester also critiqued the paper at the forum attended among others by former Fed Chair Ben Bernanke, Fed Vice Chairman Stanley Fischer, and the second-in-commands at the European Central Bank and the Bank of Japan.

Mester said economists were more apt to estimate the impact that raising rates too soon would have on employment and lost output, “but they are less likely to quantify the costs of waiting too long.”

The paper cited decades worth of data from many countries to conclude that, contrary to much economic theory, trend economic growth is not a clear determinant of where a central bank should aim to settle its policy rate over the long run.

In an acknowledgement that the U.S. economy may not be able to grow at its pre-recession rate, in recent years Fed officials have slightly lowered their forecasts of this equilibrium rate from a longstanding assumption of 4 percent.

The co-authors, including professors James Hamilton and Kenneth West of the National Bureau of Economic Research, suggest it has fallen only slightly to perhaps 3-4 percent.

Dudley, a permanent voter on monetary policy and a close ally of Yellen, said the fed funds rate will likely settle around 3.5 percent. He added that financial market conditions have become a much more important factor in setting policy.

Using Fed computer models, the paper suggested that rates should rise about six months later than otherwise planned, and that the pace of hikes should be one-third faster, leading to a modest overshooting of the equilibrium level.

The Fed, the ECB and others have slashed borrowing costs to record levels and purchased trillions of dollars in bonds to boost inflation and kick-start recovery from the 2007-2009 recession. Investors expect the Fed to be first among major central banks to tighten, later this year.

Reporting by Jonathan Spicer; Editing by Chizu Nomiyama

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