Fed's Williams sees no rise in neutral rate from stronger growth

(Adds further quote, comments on statement)

By Howard Schneider

MINNEAPOLIS, May 15 (Reuters) - A strengthening U.S. economy has done nothing to boost the underlying neutral rate of interest, San Francisco Federal Reserve President John Williams said in remarks on Tuesday that highlight an intensifying debate at the central bank over how high rates might rise in its move to "normalize" monetary policy.

At issue are varying estimates of the neutral rate of interest, and whether current stronger growth may lift it, as Fed vice chair for financial supervision Randal Quarles and some others have recently suggested.

Williams, about to also assume a vice chairmanship as head of the New York Fed, said in remarks to the Economic Club of Minnesota that he thought such optimism was "misplaced". The neutral rate remained mired at around 2.5 percent by long-term forces like an aging population and global demand for safe assets, he said.

The neutral rate is a level of interest that is seen as neither encouraging nor discouraging economic decisions, and is consistent with both stable inflation and strong employment.

The Fed's benchmark rate would approach 2.5 percent after just three more rate increases, which could take place perhaps even by the end of this year. This would force the Fed to acknowledge the decade-long era of "accommodative" policy had ended, recast its policy statement accordingly, and provide some sense of what happens next, he said.

Williams said he agreed that continued rate increases were "the right direction for monetary policy,". But he sees no evidence the neutral rate is rising despite a positive outlook and "tailwinds" including fiscal policy that may mean stronger growth.

"Even (Taiwan OTC: 6436.TWO - news) as we raise rates, I’m conscious that the fundamental drivers that govern r-star (the neutral rate) are lower than we’ve seen in the past. With (Other OTC: WWTH - news) a new normal for short-term rates of around 2.5 percent, interest rates are likely to remain low relative to historical experience," he said.

Some consensus around the neutral rate is central to the Fed's policymaking in the coming year, and will take shape when the Fed signals to the public that the era of loose policy is over.

The current Fed policy statement has for years described policy as "accommodative" and included a pledge that it was likely to stay that way.

"Over the next period of time we will have to revisit that...That language kind of served its purpose," Williams said. But with different estimates of neutral, and whether it is remaining steady or increasing, "that would be a committee decision about how to best describe the committee's view around where monetary policy is positioned and where we see it going."

Williams has been among the most active of Fed policymakers in researching and developing methods to estimate the neutral rate.

As New York Fed president with a permanent vote on the rate-setting Federal Open Market Committee, his influence on the issue may well increase. Incoming (Other OTC: ICNN - news) vice chair Richard Clarida is also considered an expert on the topic.

"Some economists and central bankers have pointed to signs that the fortunes of r-star are set to rise," Williams said. "I wish I could join in this optimism, but I don’t yet see convincing evidence." (Reporting by Howard Schneider; Editing by Andrea Ricci and Chizu Nomiyama)