Fed's Williams says US economy in good shape

Forecasts unemployment, now at 4.9%, to fall to 4.5% in the coming year and inflation to rise to the Fed's 2% target in the next year or two

A top Federal Reserve official on Tuesday repeated his call for gradual interest rate hikes, evidently unfazed by a slowdown in US job gains and sluggishness in the services sector that now has traders betting against any rate hike at all this year.

It "makes sense to get back to a pace of gradual rate increases, preferably sooner rather than later," San Francisco Fed President John Williams said in remarks prepared for delivery to the Hayek Group.

In his prepared remarks Williams did not address the release of data on Tuesday that showed activity in the US services sector had hit a six-and-a-half-year low, or government data last Friday that showed US employers added fewer jobs than expected in August.

Williams said the economy was in "good shape," and he forecast unemployment, now at 4.9 per cent, to fall to 4.5 per cent in the coming year and inflation to rise to the Fed's 2 per cent target in the next year or two.

Longer-term, however, Williams made it clear he is far from comfortable with the Fed's current approach to monetary policy.

Targeting low inflation, as the Fed and many other central banks currently do, simply will not work well in a world where economic growth and interest rates are likely to be persistently lower than they were in the era before the Great Recession, he said. A low inflation target, he said, gives the Fed too small a buffer to fend off future shocks.

The Fed could raise its 2 per cent inflation target to 3 percent or even 4 percent, or shift away from inflation targeting altogether and instead target a nominal level of national economic output, Williams said.

He said that because it will take time to figure out which approach will work best when faced with future downturns, the Fed needs to get cracking.

"Time is not on our side," Williams said.

Williams first raised the idea of ripping up the Fed's monetary policy playbook last month, when he also began advocating more strongly for a rate hike.

Fed Chair Janet Yellen said last month that the Fed was not currently actively considering any of the strategy shifts that Williams had argued for, and it is not clear how much traction his ideas have gained.