For Dudley this speech was on the dovish side

For Dudley that would be described as a bit more dovish than his other outings this year, and it may contribute to the weaker USD trend.

The key difference from other speeches from Dudley is that he acknowledged some of the fall in inflation was structural, and implied this might lower the path of hikes.

He started off by keeping to the script of above trend growth, gradual tightening labor market, fading impact on inflation from temporary idiosyncratic price falls, and gradual policy tightening, but a lower path and end point than previous cycles.

He did add in that the weaker USD will help lift inflation too.

He said balance sheet normalization (QT) should exert some modest policy restraint “over time”, suggesting this might slow pace of rate hikes a bit.

He noted that “The softer dollar and solid growth abroad also suggest that the trade sector will no longer be a significant drag on economic growth.”

On a more dovish side, he thought that not all of the recent price fall was due to idiosyncratic temporary price falls.

He has been “surprised by the persistence of the shortfall” in inflation.

He said “its persistence suggests that more fundamental structural changes may also be playing a role.  These include the increased ability of prospective buyers to compare prices across different sellers quickly and easily, the shift in retail sales to online channels of distribution from traditional brick-and-mortar stores, and the consequences of these changes on brand loyalty and business pricing power.”

He described how this could be a good thing, but it basically means the Fed could target even lower unemployment and allow stronger growth without stoking inflation; ie. lower rates for longer and a weaker USD.

He said he did not expect the Texas flood to make a big difference to the trajectory of the economy, implying it will not factor much in monetary policy.  Although he did say it will make it “more difficult to assess economic data in the months ahead”.  If it’s more difficult, it might favour delaying further tightening, so at the margin this is a bit dovish, but the market should be expecting as much.

More on the hawkish side, he suggested that easy financial conditions meant that the Fed should push on with policy tightening, even though it might expect to remain below the inflation target for a while yet.  (But this is not a new theme from Dudley).

He said, “This judgment is supported by the fact that financial conditions have eased, rather than tightened, even as the Fed has raised its short-term interest rate target range by 75 basis points since last December.  For example, equity prices have risen, credit spreads have narrowed modestly, longer-term interest rates have declined, and the dollar has weakened.”

He noted that the effect of rising short term interest rates works through their impact on financial conditions (the dollar, yields, equities, and credit spreads).  As such, the hikes since December have not actually tightened conditions, and this is reason enough to keep hiking.

He said, “All else equal, an easing of financial conditions may warrant a somewhat steeper policy rate path.”

On the other hand, he said he was not concerned that easy monetary policy was unduly pumping up asset prices and causing financial stability risks.

He said, “My view is that asset valuations are not particularly troublesome given the economic environment in which we’ve been—that is, a long period of moderate growth, low inflation, low interest rates, and low recession risks.  I would be much more concerned about asset valuations if financial market performance were disconnected from the economy’s performance—for example, if market volatility were very low and asset valuations elevated at a time when the economy was performing poorly and the outlook was highly uncertain.  Stretched valuations would also be of greater concern if credit growth were unusually strong and financial institutions were becoming more leveraged and dependent on wholesale funding.  The good news is that the substantially higher capital and liquidity requirements enacted in response to the financial crisis have helped to reduce the risks to financial stability.”

He spoke at length about technical details to do with QT.  A couple of key points were:

“Assuming that this process begins later this year and continues uninterrupted, the balance sheet size would likely normalize in the early part of the next decade.”

“Although there is considerable uncertainty about the long-run size of the Fed’s balance sheet, I would stress that the balance sheet is likely to shrink by much less than it grew between 2007 and 2014.  Based on New York Fed staff projections, I would expect the Fed’s balance sheet, which currently stands at $4.5 trillion, to shrink by roughly $1 trillion to $2 trillion.  This compares to an increase of about $3.7 trillion in the wake of the financial crisis.  This is another reason why I anticipate that the impact of balance sheet normalization on financial markets is likely to be quite mild.”