John Williams, president of the Federal Reserve Bank of San Francisco, worries increasingly about a gloomy economic future — one in which growth is lower and interest rates have little room to rise.
He also thinks the Fed should consider lifting interest rates as early as September.
As much as that sounds like a contradiction, it's not. The Federal Reserve is facing two big questions related to interest rates — one short-term and one long-term — and it's important to understand that policy makers approach them separately.
No. 1: When should the Fed next raise rates?
Since raising borrowing costs for the first time in seven years in December, the Fed has been on hold for five straight policy meetings, but progress in the labor market has been nudging the Fed closer to an increase. Strong job growth has brought unemployment down to 4.9 percent, about the level most economists believe will begin to trigger higher inflation.
Moreover, the Fed's preferred measure of inflation, after stripping out volatile energy and food components, was 1.6 percent in the 12 months through June — within "hailing distance" of the central bank's 2 percent target, as Vice Chairman Stanley Fischer put it on the weekend. "It makes sense to get back to a pace of gradual rate increases, preferably sooner rather than later," Williams said Aug. 18 in Anchorage, Alaska.
Number 2: How far can the Fed raise rates before it's no longer stimulating the economy?
This question revolves around a concept known as the "neutral rate." Put simply, it's the level at which a central bank is touching neither the accelerator nor the brake. At the moment, the Fed still has the gas almost to the floor and is thinking about easing back a bit.
Historically, economists have estimated the neutral rate to lie at around 4 percent to 4.5 percent, but those estimates have been dropping in recognition of the impact of an aging population and persistently weak growth in productivity. Some economists add other, varying explanatory factors, but the end point is the same: The potential growth rate in the U.S., and around the world, is dropping and that's dragging down the neutral rate.
Because of that, the Fed, as it increases borrowing costs, is going to hit the neutral rate at a much lower level than in past tightening cycles.
Williams, who is one of the foremost researchers on the neutral setting, has come to believe that it might be persistently much lower than in the past because of global factors. He called on his colleagues to start thinking about what monetary policy should look like in that new reality in a paper published Aug. 15. Likewise, St. Louis Fed's James Bullard sees a lower interest rate destination over the next couple of years, but still favors an increase in 2016.
There's a crucial distinction to make here: Discussion on where the neutral rate lies and how to deal with its decline won't dictate the Fed's next move, but rather will inform how high the central bank will be able to raise rates over the longer term.
"I view this as trying to push forward or initiate those kinds of conversations, thinking about the future, both in the United States and in other places," Williams said last week.
Just don't take that as an argument against raising rates this year.