John Williams isn’t mincing words when it comes to trade. It’s not just that the president of the San Francisco Federal Reserve believes trade barriers are bad for growth, he believes they are a serious risk for the US and global economy today.
“One of the bigger risks to the US and global economy is that countries on a multilateral basis would significantly raise impediments to trade, whether tariffs or other things,” he said in an exclusive interview with Handelsblatt.
The reason is simple. For Mr. Williams, who sits on the West Coast of the United States, his country lies at the heart of a huge global supply chain that runs not just north-south but extends westward across the Pacific. Asked whether he expected US President Donald Trump to follow through on threats to confront countries like China or Germany that are running current-account surpluses, Mr. Williams warned that raising tariffs would be “bad for growth, bad for jobs and bad for inflation” in the United States and elsewhere.
“I would hate to see that happen. Supply chains are integrated across the globe and throughout the US economy. That may be underappreciated by some people – just how integrated our supply chains are, so deeply built into how our economy works. Things just go around and around, especially when you think of the US relationship with Mexico and Canada and Asia,” he said. "Hopefully that won’t happen – there may be some separating of campaign rhetoric from what actually happens – but I do think that is one of the risks," he added.
If it does happen, that could have an impact on the US central bank, which is in the middle of normalizing its policy after nearly a decade of record low interest rates. Outside of the global trade battles, Mr. Williams, who in 2018 will be a voting member of the Fed’s rate-setting Federal Open Market Committee, says there are “some potential upsides to the economic outlook” that if anything could encourage the Fed to raise interest rates faster rather than slower.
While the Fed is in the middle of normalizing its interest-rate policy and is likely to start cutting its $4-trillion strong balance sheet towards the end of this year, the European Central Bank hasn’t even begun the process of reducing its own monthly bond purchases that are designed to stabilize the euro zone economy. Mr. Williams remembers the initial discussions about the Fed’s own “tapering” well. He seems to regret some of the process, which included a communication snafu by former Fed chair Ben Bernanke, who spooked markets with his first mention of tapering in what became known as the "taper tantrum" of September 2013. Rather than make the same mistake when it actually began tapering months later, the Fed chose to spell out exactly how it would taper when the time came: "We lost that optionality to adjust it, but it did reduce the [market] uncertainty."
The lesson for the ECB? Be clear from the outset about what you’re going to do, and how you’re going to go about it.
Read a full transcript of our interview with San Francisco Fed President John Williams below.
There are some potential upsides to the economic outlook.
Handelsblatt: Mr. Williams, You have recently said there could be more than three rate hikes this year. Why are you so hawkish?
John Williams: I don’t think I have been hawkish. Three rate hikes is a reasonable case given that the economy is doing well, unemployment is low and inflation is close to our 2-percent goal. There are some potential upsides to the economic outlook. We are still seeing strong job growth and inflation data have come in a little bit higher than expected. Similarly there is a possibility of fiscal stimulus that may come later this year. If that would come along, that would be another boost to the economy and we would need to take this into account in terms of policy.
In the latest minutes there was also mention of the possibility of reducing the Fed’s balance sheet at the end of this year. Are the markets really prepared for such a substantial tightening of monetary conditions?
I don’t see it as a significant tightening, as you are framing it. Market participants understand that we are going to be normalizing the balance sheet gradually over the next several years. They are already expecting that. The question is not if, but only when we start with that.
And when is the right time?
In my view it is likely to be appropriate to start the process of normalizing the balance sheet towards the end of this year. Initially we may just partially end reinvestments and partially continue reinvestments for a time. Eventually we will just end reinvestments in my view.
What does normalization of the balance sheet actually mean in terms of the figures and how long it is going to take you to get there?
We still have not decided yet what the ultimate size of the balance sheet will be. Currently the balance sheet of the Fed is above $4 trillion. But we do not know yet whether we are going to end up with $2 trillion or whatever. Over time we will come to a decision about how much liquidity we want to keep in the system. The balance sheet will be significantly smaller than today. That whole process may take 5 years or so.
Are you not worried about a large market reaction?
No, I think markets know that we are going to normalize the balance sheet. You can see it by the fact that we have been talking about it and the markets’ responses have been relatively muted. Once we start the normalization of our balance sheet, the first big step would be announcing that, but when we would progress on that we can watch our financial conditions evolve. If they tighten, we can adapt our pace of rate hikes to that.
Janet Yellen's term as Fed chair ends in early 2018 and it seems unlikely that US President Donald Trump will ask her to serve for a second term. Is this debate about reducing the Fed’s balance sheet not also linked to the debate around the succession of Janet Yellen as Fed chair, because a reduction plan could reduce uncertainty in the transition period?
That’s just speculation. In the discussions that we’ve had at the FOMC, there is a strong consensus in the committee for the approach that we have articulated in our statements. The reason that this issue is coming up now is not because of someone’s view about what the makeup of the FOMC committee will be in the future, it’s really about this interest rate normalization process being well underway. If you had asked me a year ago or six months ago when I thought the normalization of the balance sheet would happen, it would be the same answer as I’m giving you today.
More broadly on the succession issue. After 2018, when there will likely be a replacement for Janet Yellen, do you expect the political influence of the White House on the Fed to increase?
I can’t predict what will happen, but I’ve been in the Federal Reserve for 22 years and I’ve worked with governors in my different roles that have been appointed by four different presidents. First, the people who come to the Fed Reserve, whether chairs or governors, they do it because they have a strong interest in the Federal Reserve’s mission and goals. The second thing is this culture of independence, so even if you are appointed by one president or another, once you enter into the walls of the Federal Reserve you quickly take on that culture of independence and culture of nonpartisan politics.
But there have always been attempts at political interference.
Usually the political interference has involved calls to not raise interest rates - people tend to like low rates because it feels good - but we actually saw in my time quite a lot of criticism of low interest rates. So it’s symmetric. I’m hoping that Washington realizes that political interference can go either way, so hopefully the realization is ‘let’s not politicize the Fed.’
You said you hope it’s not going to happen. But do you worry about it?
You worry about it at any time. But I’ve watched various administrations realize very quickly that the Fed’s independence is valuable. If you look at comments from the administration so far about the Fed, they’ve been very positive about the importance of the independence of the Fed and the role the Fed plays, so I’m not worried in any particular way because I think the things we are hearing are consistent with the things I’ve been hearing all of my career.
Supply chains are integrated across the globe and throughout the US economy. That may be underappreciated by some people.
In Germany there has been a lot of concern about Trump’s protectionist agenda. He has blamed Germany for running a current account surplus. How justified do you think these concerns are?
One of the bigger risks to the US and global economy is that countries on a multilateral basis would significantly raise impediments to trade, whether tariffs or other things. Hopefully that won’t happen – there may be some separating of campaign rhetoric from what actually happens – but I do think that is one of the risks.
Because we know from history and from our economic models that if all countries raise tariffs significantly that would be bad for growth, bad for jobs and bad for inflation. I would hate to see that happen. Supply chains are integrated across the globe and throughout the US economy. That may be underappreciated by some people – just how integrated our supply chains are, so deeply built into how our economy works. Things just go around and around, especially when you think of the US relationship with Mexico and Canada and Asia.
Let’s go back to monetary policy. While you are raising rates at the Fed, the ECB still has to develop an exit strategy from its ultra-loose monetary policy. What are the lessons that the ECB could draw from the Fed when it comes to normalizing its monetary policy?
I am not at all expressing a view what the ECB should or should not do. One of the lessons is that you have to be very careful when you take a step that can sound like that it can be followed by another step. We had that situation with the “taper tantrum,” when the US economy had high unemployment and inflation was low. We were trying to keep rates low and we were going to slow the purchases. The other thing is that all the turmoil was about this change in the communication. When we actually executed the tapering, nothing at all happened when we did it.
Do you think the way the Fed has gone about normalizing – tapering first, normalizing interest rates second and reducing the balance sheet third – is unique?
My experience is that communication around these quantitative easing programs is just really difficult. People do not have a lot of experience with it. With QE I and QE II we were announcing a very specific quantity of bond purchases over a very specific period of time and then with QE III we did it open-ended. I pushed hard for that, but it was a lot more difficult to communicate that.
Another lesson would perhaps be to have a flexible approach, rather than announcing you will phase down bond purchases by $10 billion per month or so?
Oh boy! These are really hard decisions. When we said that we were tapering, we said that we would adjust that to the economic developments, but in the end we basically started slowing the purchases and from then on we just did it. We lost that optionality to adjust it, but it did reduce the uncertainty. That is one of the reasons once we did the tapering nobody cared. I just think you have to trade these two things off. That is also one of the reasons why I think unconventional policies like QE should not be part of everyday monetary policy, except when needed because you are at the zero lower bound.
Would you say than it is better to keep the options open for tapering?
There is no general right answer. I think it is just a trade-off. If I were in a situation where I thought I am still nervous about the economic outlook and we are still not hitting our inflation target the value of the optionality to keep all options open would be greater than in a situation where the economy is in a good place.
Let’s talk about the macroeconomic outlook. Inflation has been on the rise worldwide. Is that mostly due to oil price, or are there broader forces at play?
I think that worldwide it’s hard to say. Oil prices are clearly a driver. We at the Fed are a big believer in looking at core inflation to get at the underlying trend. In the US, with the unemployment rate lower, with the economy doing well, we definitely are seeing a modest but gradual uptick in core inflation towards 2 percent. It’s currently at 1 3/4 percent, which is closer but not there yet.
In euro area we’ve recently seen some spikes in headline inflation. Would it not be better for the ECB to focus more on core inflation that excludes food and energy, like the Fed, rather than headline inflation?
Our target is actually linked to headline inflation, too. Our 2 percent medium-term goal is headline inflation. But I do think in the US we have a longer tradition of using this core inflation excluding food and energy as a measure of underlying inflation. But there is a communication challenge: I always tell the story of my mother: I was trying to explain to her some 10 years ago that “no mom, inflation is not high, if you look at core inflation, it’s actually quite low…” She says: “You know I do drive and eat. That’s not the inflation rate I experience!” So for the ECB, the communication challenge is to get people to understand that you do still care about overall inflation – it’s really just a matter of what is best to look at to see where inflation is going. Core inflation and other measures help you do that.
The interview was carried out by Jan Mallien, Frankfurt-based correspondent of Handelsblatt, Christopher Cermak, a Berlin-based editor of Handelsblatt Global and Daniel Schäfer, Handelsblatt’s chief financial editor. To contact the authors: [email protected], [email protected] and [email protected]