By Steven K. Beckner

LOS ANGELES (MNI) – New San Francisco Federal Reserve Bank
President John Williams said Wednesday that the Fed will act “quickly”
and “decisively” to counteract inflation if it persists, but he said
that, in all likelihood, the economy is just experiencing a “temporary
bulge” in inflation that will “recede” in the second half.

Meanwhile, the newest Federal Reserve Bank president made clear he
will continue to support a very stimulative monetary policy, saying an
“extended period” of near zero short-term interest rates is justified by
“above normal” unemployment and “subdued” underlying inflation. He said
that, if it were possible, the funds rate should be “several percentage
points below zero.”

Williams contended that U.S. monetary policy accounts for a “very
small portion” of the rise in commodity prices that have driven up
headline inflation.

Although Williams, in his first speech since taking office on March
1, devoted most of his talk to inflation, he showed at least as much
concern about sluggish economic growth and high unemployment. He
predicted GDP growth will rebound from its 1.8% first quarter pace, but
said the economy faces “persistent headwinds” and said there is “a long
road ahead” to return to “normal” employment levels.

Williams, who was addressing Town Hall Los Angeles, was speaking
just hours after the Institute for Supply Management reported a
surprisingly large drop in its index of non-manufacturing activity to
52.8, suggesting a drop-off in consumer demand for services in April in
the face of high gasoline and other prices.

A highly regarded monetary economist, he served as Janet Yellen’s
director of research when she was the San Francisco Fed President before
she went to Washington last October to become vice chairman of the Fed
Board of Governors.

Williams, who was a senior economist at the Board of Governors
before coming to the San Francisco Fed, did research last year showing
that the federal funds rate should be at least minus 2% if it were
possible and therefore that quantitative easing was needed to
approximate a sizably negative funds rate.

And he reaffirmed that view in prepared remarks. “We’ve kept the
federal funds rate, our main short-term policy interest rate, close to
zero to stimulate the economy,” he said. “But 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.”

Since that is impossible, he said the Fed has been buying long-term
securities, and he said this so-called quantitative easing has succeeded
in lowering yields on longer-term Treasury securities by “about half a
percentage point below where they would be without this program.”

Referring to the Federal Open Market Committee’s commitment to
keeping rates “exceptionally low … for an extended period,” Williams
said “the reasoning behind this is that unemployment is well above
normal levels and underlying inflation is subdued.”

Looking ahead, he said “we do expect the pace of growth to pick up
and for the unemployment rate to continue its gradual decline. And the
nature of monetary policy is that central bankers must stay ahead of the
curve” because “policy acts with a considerable lag.”

“For that reason, we have been preparing a plan to start removing
stimulus when conditions warrant-our so-called ‘exit strategy,'”
Williams said, adding that the strategy will include “draining bank
reserves and reducing our holdings of longer-term securities, in
addition to raising the federal funds rate.”

Williams, who will be an FOMC voter next year, said “the exact
timing of the various stages of this plan will be dictated by the course
of the recovery and, in particular, the paths of unemployment and
inflation.”

But Williams made clear he does not think accelerating inflation is
the main challenge facing the FOMC.

“The economy today faces many pitfalls, but I don’t believe that
runaway inflation is one of them,” he said, adding that the Fed “has
learned the lessons of the ’70s and is absolutely committed to making
sure nothing like that happens again.”

“I fully share this determination to maintain price stability,” he
continued. “You can rest assured that the Federal Reserve is committed
to low and stable inflation.”

Williams said he views “a sustained period of high inflation as
very unlikely.”

“But if we see signs of it developing, then we will act quickly and
we will act decisively to ensure price stability,” he added.

Williams acknowledged that gasoline, food and other prices have
“soared” and noted that the price index for personal consumption
expenditures (PCE) rose at a 3.8% annual rate in the first quarter.
Although core PCE rose just 1.5%, he said the overall PCE inflation rate
is what “we at the Fed care about in terms of our inflation goal.”

But, after recognizing the inflation rise, he downplayed it,
saying, “I don’t think that inflation will remain stubbornly high … .
I expect it to recede.”

Williams went to some length to explain that view.

He began by defending the Fed against charges that it has caused
the run-up in commodity prices and related increase in inflation by
keeping rates too low and expanding bank reserves through asset
purchases.

Although there has been “a very substantial pickup in prices for
many energy, food, and industrial commodities,” and although low
interest rates can tend to boost commodity and other asset prices, he
said “it is unlikely that this effect can explain more than a very small
portion of the huge increase in commodity prices that we have
witnessed.”

“I don’t see any convincing evidence that monetary policy has
played a significant role in the huge surge in commodity prices,” he
said.

Rather, Williams said “the real culprit” behind the commodity price
surge is “global supply and demand” — the combination of rising demand
from “emerging market” nations like China and turmoil in the Middle East
and North Africa that has threatened oil supply.

Williams projected that “inflation rate will reach a peak around
the middle of this year and then edge back downward. In other words, we
are seeing a temporary bulge in inflation before we return to an
underlying level of about 1 1/4 to 1 1/2% annually.” He gave four
reasons for thinking “the inflation bulge will be short-lived.”

1. “commodity prices are not likely to keep increasing indefinitely
at a rapid rate.”

2. “higher commodity prices generally represent only a small
proportion of the cost of the finished goods American consumers buy.”

3. “The stability of longer-term inflation expectations … leads
me to expect that inflation will start to ease later this
year … . Medium-term measures of inflation expectations have barely
budged.”

4. “The structural and institutional factors that led to a runaway
inflationary spiral in the 1970s are largely absent today.”

“Four decades ago, many labor contracts provided for automatic
cost-of-living adjustments, or COLAs, which meant that higher prices fed
into higher wages in a self-reinforcing feedback loop,” he explained.
“Today, COLA clauses are mostly things of the past.” Counting
productivity gains, he said unit labor cost rises have been “close to
flat.”

“These wage trends, which reflect the high level of unemployment in
the economy, act as a powerful brake on inflation,” he said.

While maintaining that “the risk of a sustained period of high
inflation is low,” Williams said he “will be paying very close attention
to incoming information to watch for shifts in inflation trends.”

“If inflation significantly exceeds our forecast, if commodity
prices do not stabilize, if the pass-through of commodity and other
import prices to consumer prices is higher than we expect, if long-term
inflation expectations start rising significantly, or if a wage-price
spiral starts to emerge, then I will modify my views accordingly,” he
pledged.

Williams prefaced his relatively sanguine views on inflation risks
with continued concern about the economy.

Despite recent payroll gains, he noted “there are still over 7
million fewer jobs in the United States than we had before the downturn.
The recovery has sputtered at times and our forward progress has been
disappointingly slow.”

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** Market News International Washington Bureau: 202-371-2121 **

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