By Steven K. Beckner

LOS ANGELES (MNI) – New San Francisco Federal Reserve Bank
President John Williams said Wednesday that if the U.S. economy
improves as expected, at some point the Fed will start to remove
monetary stimulus, but cited downside risks to the outlook and didn’t
rule out the possibility of further quantitative easing.

Williams, talking to reporters following a speech to Town Hall Los
Angeles, said he did not want to “prejudge” the need for more Q.E.,
however, observing that the Fed is now closer to both its inflation and
unemployment goals than it was when it launched QE2 last November.

The newest Fed president, who will be a voting member of the Fed’s
policymaking Federal Open Market Committee next year, gave no sense of
the timing or pace of the Fed’s “exit” from a very accommodative
monetary policy, but said it will be “calibrated” to the performance of
the economy and the Fed’s forecast of employment and inflation.

Williams said he does not expect any “dramatic” or “cliff” effects
when the Fed’s QE2 program of buying $600 billion in longer term
Treasury securities comes to a scheduled conclusion at the end of June.
He said he does expect a “diminishing” effect of Q.E. on yields over
time, however.

Williams said anchored inflation expectations, among other things,
should ensure that the recent upsurge in inflation proves to be just a
“temporary bulge.” He said he does not see much “monetary tinder” for
inflation as he watches the monetary and credit aggregates. And he said
the Fed’s ability to pay interest on reserves will enable it to control
the extent to which reserves flow into the economy through lending and
increase the money supply.

In his earlier prepared remarks, he echoed research he did when he
served as director of research for former Fed presideng and current Fed
vice chairman Janet Yellen when he said, “standard rules of thumb
indicate that, with the economy in such a deep hole and underlying
inflation low, the federal funds rate should be several percentage
points below zero.”

Williams also said the economy is growing slower than all
macroeconomic models say it should and pointed to bother “transitory”
and “persistent headwinds” to recovery. He said the economy has a “long
way to go” to return to “normal” levels of employment.

In light of those comments, MNI asked Williams whether additional
Q.E. might be needed and whether it would do any good.

As for whether “more asset purchases have any beneficial effects,”
Williams said his analysis and his “reading of the literature” tells him
that “a further increase in the balance sheet … would have the same
kind of effects as in QE2.”

He had earlier estimated that QE2 had reduced long-term interest
rates by at least 50 basis points.

But that doesn’t necessarily mean the Fed should do more, he
indicated. “The question of whether we would need or want to do more …
would depend completely on what … the economic forecast” is, … where
we are in terms of employment and unemployment and inflation.”

“I don’t prejudge whether we would need more or not need more”
Q.E., he said. “It would be based on forecast for those key
variables.”

Williams suggested that the cost and benefit weightings have
changed since QE2 was launched last November, noting that inflation has
risen, while unemployment has fallen since then.

“Today both of those conditions are closer to where we want to be,”
he said, adding that “the risk of deflation is less.”

Williams said “doing more stimulus would help bring unemployment
down further,” but would “also increase inflation…”

He added that “there is still a lot of uncertainty about asset
purchases.”

Although the risk of deflation has lessened, Williams said there
are “downside risks” to growth and said it is possible that inflation
could fall again to uncomfortable levels. A decline in inflation to
below 1% or even to half a percent is “not outside the band of error,”
he said.

But Williams appeared to be leaning more in the direction of an
eventual tightening. He said the FOMC’s decision to end QE2 was “the
right thing to do” and leaves “the right amount of stimulus.”

He said “a lot of monetary stimulus” is in place, but suggested
that is justified because “we’re in a very difficult situation … far
from our mandated goals.”

Going forward, “if the economy improves as we expect, in terms of
unemployment coming down, inflation stalling out … to slightly below
2%,” Williams said that “eventually … we will want to remove some
accommodation,” though “not all.”

When the time comes, the Fed “will take steps to remove
accommodation” using both reserve reduction measures and interest rate
hikes.” The Fed will use both kinds of tools “when that’s appropriate.”

The timing and pace of exit “really depends on what happens to the
economy between now and then,” he said, noting “we get head fakes on the
economy” frequently.

“We really want to get a very consistent picture of where we are in
terms of the recovery,” he said, so the timing of tightening is “going
to depend on the actual data and depend on our analysis” of the data.

“We’re not going to turn course any time immediately,” he added.
“We’ll have to wait and see how things develop.

As for the pace of eventual tightening, Williams said that if the
economy improves only slowly the pace of exit “will be calibrated to
that.” If faster, then the pace of exit “will be quicker,” he said.

Williams said he has “complete confidence in our ability” to
tighten its unconventional monetary policy but acknowledged that it will
be “complicated” to explain exactly what it is doing to the public. So
he put a premium on clear and effective communication of the exit
strategy.

Like many of his colleagues, Williams put great importance on
keeping inflation expectations anchored, but MNI asked whether,
irrespective of expectations, the Fed was running the risk of providing
the “monetary tinder” for inflation by keeping rates low and bank
reserves large.

Williams said he keeps a close eye on monetary and credit
aggregates as well as asset prices and other measures of financial
conditions and concluded, “In my view, there is not a lot of tinder
out there.”

Before the Fed had the ability to pay interest on reserves, he
said there was a greater danger of reserve expansion leading to
excessive money supply growth, but he said the Fed can now better
control that.

Williams was also not concerned that the impending end of QE2 will
lead to an upsurge in bond yields.

“I think my view of how quantitative easing or large scale asset
purchases works is through the stock effect of the balance sheet … the
amount of securities we’re holding or anticipate to hold…,” he said.
So “I would not expect there to be some kind of cliff effect” at the end
of June.

“I wouldn’t expect to see some big move (in yields) because
purchases have ended,” he continued, but “as we move
forward in time … as the time that markets expect exit to take place
gets closer … the effect of asset purchases will start to
diminish.”

** Market News International **

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