Fed on road to 'normal' may be rocky: Williams

Painting a largely upbeat picture of the economic outlook, San Francisco Fed President John Williams forecast 3 percent growth this year and next, a return to a normal U.S. job market by 2016, and a rise in inflation toward the Fed's 2 percent target over roughly the same period.

Improvement in the economy over the last year or so has allowed the Fed to begin to cut back on its massive bond-buying program, with a view to ending it in October or December, he told reporters, saying he had no personal preference on the exact timing.

Still, "A real tightening of policy, which would mean raising the fed funds rate, is still a good way off," Williams said. The fed funds rate, at which banks lend to each other overnight, has been held near zero since December 2008, and the Fed has said it will stay that way for a "considerable time" after bond-buying ends.

"As we get closer to be in a position where we think it's time to raise interest rates, there will be hints of that and discussion of that in people's speeches, and you will definitely see that, I think, presumably, in the economic projections of (Fed policy-setting committee) participants," Williams told reporters. "As you get closer, hopefully we'll be better able to communicate what our thinking is about the appropriate time and pace of liftoff."

But Williams warned that the Fed's super-easy monetary policy over the past five years has left financial markets vulnerable, making the road to normalcy a tricky one to navigate.

"We have to be kind of careful and gradual about how we communicate and how we move our policies, recognizing that even though it seems like this should go smoothly, it may not," he said.

"There's stuff going on that could lurch when we do our normalization of policy. Williams noted that the Fed has in the past overestimated its grasp of market psychology, most notably when the Fed Chairman Ben Bernanke last year hinted that the Fed could soon trim its bond-buying program.

Shorthanding his own interpretation of the unexpected market swoon that ensued, Williams on Thursday said it seemed to him that "Ben Bernanke went out there and said something that (markets) already knew, and they freaked out."

As for the running debate over whether short-term unemployment, which is near historical norms, better signals the health of the labor market than long-term unemployment, which is high, Williams said it is "an intellectually fascinating" issue.

But no matter which side is right, wages, which have been flat, should begin to rise as the labor market tightens, he said.

"The policy implications (of the debate) don't seem to be that big to me," he said.

(Reporting by Ann Saphir; Editing by Meredith Mazzilli and Steve Orlofsky)