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Fed’s Dudley Sees ‘Relatively Slow’ Pace of Tightening

NY Fed President William Dudley
Federal Reserve Bank of New York President William Dudley presented a detailed outline of his thoughts on the economy, monetary policy and the exit strategy, views he is likely to bring to the June 17-18 meeting of the Federal Open Market Committee, the Fed panel that sets interest rates. Photographer: Scott Eells/Bloomberg

Federal Reserve Bank of New York President William Dudley said the pace of eventual interest rate increases “will probably be relatively slow,” depending on the economy’s progress and how financial markets react.

A “mild” response “might encourage a somewhat faster pace,” Dudley said today to the New York Association for Business Economics. “If bond yields were to move sharply higher,” on the other hand, “a more cautious approach might be warranted.”

Dudley presented a detailed outline of his thoughts on the economy, monetary policy and the exit strategy, views he is likely to bring to the June 17-18 meeting of the Federal Open Market Committee, the Fed panel that sets interest rates.

Fed officials in April trimmed stimulus for the fourth consecutive meeting, saying the economy has strengthened after harsh winter weather slowed growth to a 0.1 percent annual pace in the first quarter. Policy makers cut monthly bond purchases, aimed at holding down long-term interest rates and fueling growth, by $10 billion to $45 billion.

Dudley said he expects growth to pick up for the remainder of this year and next, gradually lifting inflation toward the Fed’s 2 percent target. Under that scenario, he said, he would continue to favor a gradual reduction in asset purchases. He repeated the Fed’s view that a “considerable period of time” will elapse between the end of quantitative easing and the first interest-rate increase.

In a footnote to the text of his speech, Dudley said “it is worth noting” that eurodollar futures show investors anticipate a rate increase around the middle of next year, in line with the forecasts of policy makers released in March.

Growth Trajectory

“I expect the economy to get back on to a roughly 3 percent growth trajectory over the remainder of this year, with some further strengthening likely in 2015,” he said, adding that “considerable uncertainty” remains in the forecast.

Drags on growth appear to be abating, he said. Household wealth is stabilizing as stock and housing markets recover and consumers pay down debt. Tight fiscal policy should reduce gross domestic product in 2014 by about half as much as it did last year.

“Business fixed investment and housing are two key areas where activity has been disappointing,” he said. “They need to kick in more forcefully for the economy to grow at an above trend rate for a sustained period.”

In the longer term, Dudley said, he expects interest rates to stay “well below” historical averages, in part because the labor force will expand more slowly as the population ages, reducing the economy’s potential growth rate.

Rate Equilibrium

Responding to an audience question, Dudley said market expectations for where rates are likely settle in the long term are declining. “People are reevaluating their view of what the long-term equilibrium short rate is,” he said.

He also said he’s concerned about “unusually low” volatility in financial markets.

“It’s not just fixed income, it’s fixed income, foreign exchange, and equities,” he said. “That makes me a little nervous.”

Stocks remained lower after Dudley’s remarks, with the Standard & Poor’s 500 Index declining 0.7 percent to 1,872.83 at 4 p.m. in New York. The yield on the 10-year Treasury note fell to 2.51 percent from 2.55 percent late yesterday.

The New York Fed president also said the 2 percent inflation goal “is definitely not a ceiling.”

Inflation Objective

“If inflation were to drift above 2 percent, all else equal, then we would tend to resist such a rise,” Dudley said. “But, if inflation were slightly above 2 percent even as unemployment remained far above levels consistent with maximum employment, then the unemployment consideration would dominate because we would be further from the unemployment objective than we are from the inflation objective.”

Fed Chair Janet Yellen said in May 7 congressional testimony that the central bank will probably end bond buying in the fall if the labor market continues to improve. U.S. payrolls rose last month by 288,000 in the biggest gain in two years, and the 6.3 percent jobless rate was the lowest since September 2008, according to a May 2 Labor Department report.

Still, Yellen said “a high degree of monetary accommodation remains warranted” with indicators for inflation and employment far from the central bank’s goals.

On the exit strategy, Dudley said ending reinvestment of maturing assets prior to the first rate increase “may not be the best strategy.”

Near Zero

First, it could complicate communications about when the committee intended to raise interest rates, he said. Second, he added, the Fed panel should be focused on getting off near-zero interest rates “in order to regain some monetary policy flexibility.”

Policy makers have been considering ways to tie up excess liquidity when they decide to tighten monetary policy. Such tools, under the purview of the Fed Board, include the Term Deposit Facility, in which the Fed pays banks a premium on their funds in exchange for leaving their money in the facility, and interest on excess reserves, or the amount the Fed pays banks for money deposited at the central bank.

The Fed since September has experimented with an overnight, fixed-rate reverse-repurchase program to drain cash from the banking system. In a reverse repo, the central bank lends securities for cash for a set period. At maturity, the securities are returned to the Fed, and the cash to primary dealers. The FOMC oversees the reverse repo program.

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