John Williams, current president of the San Francisco regional branch of the Fed. (Photographer: David Paul Morris/Bloomberg)

Williams Says Fed Shouldn't Be Afraid to Invert the Yield Curve

(Bloomberg) -- The Federal Reserve shouldn’t hesitate to invert the yield curve if raising short-term interest rates above long-term yields becomes necessary to achieve the U.S. central bank’s targets, New York Fed President John Williams said.

“We need to make the right decision based on our analysis of where the economy is, and where it’s heading, in terms of our dual mandate goals,” Williams said Thursday while speaking to reporters after an event in Buffalo, New York. “If that were to require us to move interest rates up to the point where the yield curve was flat or inverted, that would not be something I would find worrisome on its own.”

Over the last six months, the yield on 10-year Treasury notes has fluctuated around an average of 2.9 percent, while the yield on the two-year note -- which is more sensitive to expectations about the federal funds rate -- has risen about 0.4 percentage point. As a result, the spread between the two, known as the yield curve, has compressed to about the narrowest level since 2007.

Historically, an inverted yield curve -- where short-term rates rise above long-term ones -- has preceded economic downturns. Williams, who left his job running the San Francisco Fed for New York in June, said policy makers should be careful in today’s environment about drawing conclusions from the past.

Williams Says Fed Shouldn't Be Afraid to Invert the Yield Curve

“In thinking about the historical experience of the yield curve, we do have to be cautious about applying it to this current situation,” he said. “We and other central banks around the world have taken aggressive actions to buy lots of long-term assets, which has arguably pushed down the term premium, or the yield, on 10-year Treasuries.”

Employment, Inflation

As New York Fed president, Williams holds a permanent vote on the central bank’s rate-setting Federal Open Market Committee, whereas presidents of other regional Fed banks rotate in and out of the voting roster.

During the event in Buffalo billed as a fireside chat, Williams gave an upbeat view of economic conditions, saying “this is about as good as it gets” in terms of achieving the Fed’s dual mandate of maximum employment and low, stable inflation.

Williams said the Fed isn’t seeing many signs of inflationary pressure at the moment, in part because falling unemployment hasn’t resulted in a jump in wage gains.

“The fact that wages haven’t grown a lot faster is a sign that this economy still has room to run,” he said, adding that as a result, “we don’t feel the need to raise interest rates more quickly than otherwise.”

Neutral Rate

The U.S. unemployment rate fell to 3.9 percent in July, while a widely-tracked gauge of underlying inflation ticked up to 2 percent, matching the Fed’s target. According to projections published in June, the median FOMC participant thinks the minimum unemployment rate consistent with stable inflation is 4.5 percent.

That helps explain why policy makers expect they will probably need to raise the federal funds rate above its estimate of the so-called neutral interest rate some time next year.

The neutral interest rate is the rate that in theory would keep unemployment stable. Williams said he expects the jobless rate to continue to fall.

The current target range for the federal funds rate is 1.75 percent to 2 percent. The June projections show most FOMC participants see the neutral interest rate as around 2.75 percent to 3 percent, with the median estimate for a fed funds target range of 3 percent to 3.25 percent by the end of 2019.

Williams noted that estimates of the neutral rate haven’t moved much in the past couple years. “I don’t see any clear signs why I would expect that trend to change very much,” he added.

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