FOCUS-NY Fed chief ties rate hike to current account
By Marjorie Olster
NEW YORK, Nov 22 (Reuters) - The Federal Reserve's decision to raise interest rates last week was based at least in part on concerns U.S. demand is outstripping supply, which in turn inflates the current account deficit, New York Fed President William McDonough said on Monday.
McDonough's comments were the first from a top Fed official indicating that uneasiness about the swelling trade imbalance figured into the Fed's decision last Tuesday to raise two key interest rates by a quarter percentage point.
``A somewhat firmer monetary policy no doubt has some beneficial effects in bringing better order to our foreign accounts,' McDonough told a Foundation for Student Communication conference.
Spelling out what the Fed sees as one of the major imbalances that could derail a nearly nine-year-old expansion, McDonough said domestic demand has been running in excess of supply, and that gap is being filled by ``importing savings' from other countries.
``The very large current account deficit that we have now ... is not a good idea. ... At some stage, foreign holders of American assets -- be they bonds, stocks or foreign direct investment -- are going to think that they have had quite enough,' he said.
``That combination of things is what led us to the conclusion that the rates should be increased.'
The deficit in the U.S. current account, the broadest measure of trade with the rest of the world, ballooned 17.5 percent in the second quarter to a record $80.67 billion.
When the trade gap worsened during the global financial crisis in 1998, that was seen as a reflection of the relative health of the U.S. economy and strength of domestic demand that made the U.S. consumer the ``consumer of last resort'.
The Fed kept U.S. financial markets on track and eased some of the global strains when it cut interest rates three times in rapid succession in the fall of 1998.
But this year, the Fed's focus has switched firmly back to domestic economic concerns, and with that came three rate hikes and increasing reminders that the current account deficit is not sustainable.
The Fed last week raised the federal funds rate on overnight loans between banks to 5.5 from 5.25 percent and the discount rate on direct borrowing from the central bank to 5.0 from 4.75 percent.
McDonough praised central bankers for recognizing that their old economic models, which saw a stable tradeoff between growth and inflation, were no longer effective and the economy was behaving differently in these days.
``Our view now is the economy can grow at 3.5 percent per year,' McDonough said. ``As long as the rate of productivity continues to rise, you can have the economy continue to grow faster without inflation.'
For years, Fed economists had theorized that the economy's potential rate of growth was around 2.0-2.5 percent and if it exceeded that ``speed limit' inflation would begin to accelerate.
But the upswing in productivity in the past few years and a falling unemployment rate without accompanying inflation have forced the Fed to rethink old equations.
``We didn't fight it. We allowed the American economy to grow. That is I think our finest hour,' McDonough said.
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