Tax cuts risk overheating U.S. economy, warns Fed official

U.S. economy adds 148,000 jobs in December
U.S. economy adds 148,000 jobs in December

New York Federal Reserve President William Dudley is worried new tax cuts could risk overheating the U.S. economy in the next few years.

Economic prospects in 2018 are looking "reasonably bright," Dudley said in a speech to the Securities and Financial Markets Association on Thursday. He expects unemployment to remain low and wages to quickly rise.

But Dudley warned that central bankers may have to "press harder on the brakes" at some point in the next few years to help stave off a possible recession.

Dudley said faster economic growth from tax cuts when the labor market is healthy and lending is cheap could cause the economy to grow too quickly. He has previously called the tax cuts unnecessary at a time when the economy is already growing at a steady pace, which is likely to help increase inflation over time.

If the economy grows too fast, he said the Fed will have to raise interest rates faster than expected. That could make borrowing money more expensive -- the federal funds rate helps determine lending rates.

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"If that happens, the risk of a hard landing will increase," said Dudley, meaning central bankers will be unable to head off an economic recession. And if history is any indication, he said central bankers have often found a so-called soft landing "difficult to achieve."

Overall, rates are still historically low, hovering in a range of 1.25% to 1.5%. Central bankers have already penciled in three rate increase this year, and two more in 2019.

Dudley cautioned the tax cuts could also drive up the country's deficits.

"After all, there is no such thing as a free lunch," he said. "The current fiscal path is unsustainable."

He said ignoring budget math would wind up driving interest rates, reducing private sector investment and diminishing the country's creditworthiness.

"These dynamics could counteract any favorable direct effects the tax package might have on capital spending and potential output," said Dudley.

Related: Janet Yellen: Tax plan's deficits could make it harder to fight a recession

The risk of overheating "seems like an odd issue to focus on when inflation is low, but it strikes me that this is a real risk over the next few years," he said.

So far, inflation has fallen short of the Fed's target of 2%. It's mystified Fed officials, but Dudley and other policymakers anticipate it will rise to normal levels over time.

The job of central bankers is to shift policy levers, nudging interest rates higher and lower, to boost jobs and keep prices, or inflation, at the optimal level. That means not too high, and not too low.

When inflation is too low, it can hurt the economy. Businesses get queasy about investing in people and equipment. If prices don't rise, wages don't either. But out-of-control inflation can also be harmful.

Dudley will step down from his post in the middle of this year.

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