The Fed: Cleveland Fed’s Mester says the Italian turmoil and a flattening yield curve haven’t changed her interest-rate view

Loretta Mester, president of the Federal Reserve Bank of Cleveland, spoke to MarketWatch in an exclusive interview.

The market may have encountered a fresh round of turmoil, but Cleveland Fed President Loretta Mester’s message on the U.S. economy and how many interest-rate hikes are needed has stayed just as it was.

“Whether it’s three or four, I know the markets want to know exactly that, but in terms of the economy and the macroeconomy, I think that is less important. I think the important thing is we need to be moving the funds rate up gradually because the economy is improving, and we’re getting at our goals,” Mester said in an exclusive interview with MarketWatch from her elegant office in Cleveland.

Neither worries about contagion effects from the turmoil in Italy or a flattening yield curve has persuaded Mester to rethink her support for gradual rate hikes.

Mester threw cold water on the idea that wages are somehow mysteriously low. The fact is that worker compensation is rising and soon will be reflected in the statistics, she said.

In a wide-ranging interview, Mester, who is a voting member of the Fed’s policy committee this year, said she didn’t think inflation would spike. She said she could tolerate “a couple” of inflation readings above 2%. She stressed that the data would dictate the path of policy, and the impact of the Trump tax cut and congressional spending package would be much clearer later this year.

Let’s talk about the steep market reaction on Tuesday to the situation in Italy. The 10-year yield TMUBMUSD10Y, +0.09% dropped although it has recovered a bit. The market had a big scare. How do you view things like that?

So far, it hasn’t changed my view about the fundamentals of the U.S. economy. But you certainly have to take this on board as like, “OK, we knew there was geopolitical risk, this is one of the manifestations.” You can always spin a scenario that is a dire scenario because their debt levels are high in Italy, and maybe that will have some contagion back to their banks, so you worry those kinds of things. So there are risks — not my modal outlook at this point — but you certainly want to watch these things as they develop and make sure you are positioning yourself in good stead. Not surprising how the markets SPX, -0.69% reacted, I would say, in the U.S. to those events.

Does it make the Fed more cautious?

I mean, I would say no, in the sense that we knew that what was going on in the political situation in various countries in Europe could have an implication for financial markets and volatility. So that was already on the radar screen. We still have two weeks until the June meeting, and so we’re going to all be looking at this very carefully. But, again, I think my mode of doing this is always likely to obviously be very attentive but also think about, you know, you don’t want to react and be jerked around in terms of short-run moves in the markets.

The economy has been expanding for 107 months, second longest on record. Some people on the Fed don’t want too many more rate hikes, saying the best way forward is to keep things steady, but you’re in the camp of more rate hikes.

I think the gradual upward path that was in the last [statement of economic projections] is right because I view the economy as a bit beyond full employment from the point of view of what monetary policy can effect. I believe that inflation is moving up toward, and will be at, our goal of 2% sustainably over the next year or so. And so, in that environment, we have still accommodative monetary policy. And so it is a calibration exercise. There is no reason to go aggressively on interest rates. I don’t foresee that inflation is going to spike and pick up aggressively.

But, at the same time, we know that, as the economy continues to grow, we are a little beyond full employment. The unemployment rate, I expect, will continue to come down even further. Inflation is moving up; you don’t want to not be attentive to that, either. And so this gradual path I think is the right calibration. I don’t think it is a good strategy to try purposely to overheat the economy because I think that could lead to bad outcomes. I think it is too experimental, so to speak. Why gradual? Because I don’t see inflation picking up aggressively. So I don’t think there is any argument to go faster. I don’t see obvious bubbles anywhere.

How do the Trump tax cut and congressional spending plan impact this?

So those are upside risks, the way I view it. So far, it doesn’t look like that has generated a lot of excess. I think we are all going to have to wait and see how it plays out. Some of the contacts that we talked to, our board of directors, they say, well firms had positive outlooks so they built-in investment plans. They are on their plan. Did they up it after the tax cut? No. Wait and see whether people will be aggressively spending later in the year. So far, it seems like it is positive, but it is not, like, taking off in any big sense.

Could the tax cut and spending plans end the expansion more quickly, bring forward inflation?

I think the way I would look at that is it is an upside risk to growth. If the economy starts to move more strongly, for whatever reason, than is built into our forecast, we might have to change our policy path. If growth picks up more than we anticipated, that would argue for a bit steeper path. If inflation stays low for longer than we think [then] maybe we would say go a little slower. I don’t think any one event we are going to react and try and set our policy path to how the economy evolves and what the evolution of the forecast is.

So it will be later this year when it will be clearer?

I think we will have better insights into the effects of the taxes and the government spending later in the year. I mean certainly it took a while on the household side for some of the tax changes to even get into paychecks, and then it took awhile for people to get their tax refunds this year for last year, so there are always these timing issues. But you know, strong labor markets, wages are going up, personal incomes are high, there is strong underlying fundamentals here that I think argue for continued growth above trend.

In the Fed minutes, the staff said there were upside and downside risks from fiscal policy.

Well, it’s timing, isn’t it? I can’t remember exactly the quote from the minutes, but the way I look at it, in the near term, there are upside risks if it comes on faster or stronger. Long run, there are deficits — we’ve added to the deficit by this spending, and that poses a risk in the long run for our fiscal sustainability, and that can impose costs on the economy in the long run. And so I think it is those two things together.

And then the third thing is we are talking demand side in the near term. What is the impact on the supply side? And that is very relevant to actually determining the fiscal-sustainability issue. So if you don’t think it is going to have much supply-side impact, and I’m somewhat skeptical that it will have big supply-side effects, then you are more worried about the longer-run impact on the deficits and the ability of the country to sort of get that fiscal side of the equation into a sustainable path.

Do you think inflation is going to go above the 2% target?

I think we are seeing some stronger inflation numbers, and I wouldn’t be surprised if inflation went above 2% in the near term. But, again, the way I look at it you are going to have volatility in these numbers. The real question is, where is inflation headed on a sustained basis? And there I think it is going to be gradually moving up and be sustainably around 2%. But it is always going to have these monthly variations in it.

There was a lot of focus in the portion of the minutes that said it might be OK for inflation to move temporarily above 2% because it might move inflation expectations higher.

I think if you look at the strategy document that actually lays out our strategy, we aim for 2% inflation on a sustainable basis. That is kind of our goal, and that’s how we do it. Am I comfortable with seeing a couple of numbers above 2%? Yes. I was comfortable with seeing numbers below 2% as long as I thought things were moving in the right direction and we were moving inflation up and our policy stance was consistent with that outlook.

So you don’t see inflation breaking out here?

Well, for one thing, I don’t think we’re behind. So if we saw inflation moving much stronger than I thought it was going to do, we’d have to adjust our policy path in response to that. Inflation expectations are pretty well-anchored. There is nothing to argue there that you were going to see this breakout in inflation. And current inflation rates, which help you predict future inflation rates, are also near 2%. So there is no piece of it that suggests we are well beyond the curve and we have to start moving things up.

But you said in your recent speech that you think monetary policy might have to become restrictive.

Well if you look at the SEP, what you’ll see there is that policy path has the policy rate going above the long-term [neutral] rate.

And that is the typical thing that you see when the policy makers are having to respond to the evolving economy. So the point I was making was, it is not necessarily going to be that we’re going to move in lockstep gradually up to 3%, the policy rate will move as we think appropriate given where the economy is going. And if you look at those forecasts, inflation moves up above 2%, too, and that kind of explains sort of that path. So, again, we have language in the current statement now that talks about [how] policy will remain below the levels that are expected to prevail in the longer run.

My point was, look, if you actually look further out … now 2020 is still way far away, we know that those policy paths are our best forecasts at the time of what we think appropriate policy will be given how we think the economy will evolve. The economy is going to evolve how the economy evolves, and we’re going to have to move our policy in response to that. So I wouldn’t put too much stock in a data point in 2020 in those forecasts. But, nonetheless, I think the point is that language about necessarily being below our longer-run level, maybe that is not necessarily going to be the kind of language you want to be [using].

Do you think it is time to take the language out?

If you look at what our forecasts are, and we’re going to get new ones, so that will give us more data points, that probably we need to think about that language in the statement.

A lot of your colleagues talk in terms of getting to neutral and taking a look around. In the short run, where do you think neutral is?

I think that is right, there is short run and there is long run, and that is a good way to be thinking about this. Given the strength in the economy I can imagine the short-run R-star [a theoretical equilibrium rate of real interest] is going to be moving up and therefore we’re going to want to move. And that is one argument for why we want to move up the funds rate because we don’t want to get behind the curve. In the long run, I’m at 3% nominal fed funds rate. So, again, we have to move our funds rate up in lock step with real interest rates, and I see them moving up.

So is 3% your short-run neutral rate?

No. Right now I can’t give you a number. But it is moving up from where it was. We are still accommodative.

But not many more moves until before you are no longer accommodative? That’s what I’m trying to get at.

I still think we are accommodative now. We are probably close to being neutral, but I don’t think it’s static. That’s my problem with answering your question. This is dynamic. There are a lot of moving parts here. It is where our policy rate is, but it is also where it is relative to the economy. And that neutral rate is dependent on the economy.

Sometimes it is useful to have a definition of a short-run neutral rate, a guesstimate.

Well I think the best way then is to look at the long-run funds rate [just under 3%]. That is the best way to think about that. We think that in the longer run that’s where neutral is. And we’re going to adjust our policy as the economy gets to that longer run.

So does the pace of a quarter-point hike per quarter — is that a good pace for you?

My forecast is very consistent, I would say, with the median path. I’m a bit more optimistic on growth, or I was a bit more optimistic on growth than others, so I had a little bit steeper path. But that, whether it’s three or four, I know the markets want to know exactly that, but in terms of the economy and the macroeconomy, I think that is less important. I think the important thing is we need to be moving the funds rate up gradually because the economy is improving and we’re getting at our goals. I think if we do this path, and we do it well, the economic expansion continues. We want to make our goals. Why those are sensible goals is that means it is a healthy economy. So I think we focus on making our goals. If we do it well, then we are in a sustainable expansion. So now that the economy is strengthening, we had better calibrate our policy to that stronger economy. We don’t want to go too aggressively, but we don’t want to also get behind. So that’s the challenge here.

It seems like the big decisions will come in 2019. This year’s rate-hike path seems almost baked in the cake.

I like the gradual path we are on, but, again, the economy can evolve in ways that we don’t anticipate, so we are just going to have to be watchful and try to do the best we can in terms of setting our policy based on the outlook. But also be willing to not to be wedded to a path that is inconsistent with the outlook. So I don’t think it is that easy.

On the mystery of low wage growth, it seems you think wages are rising more than people think?

We’ve gotten a lot of anecdotal evidence from business contacts and even from people on the other side who are placing workers that wages are going up. So I think, anecdotally, that is there and it is a matter of time before it will show up. I don’t think it’s as big a mystery once you remember that inflation was low for a long time and productivity growth was low for a long time and continues to be low. We have gotten some acceleration; it is just not as much as we saw in the last expansion. But I think a lot of that explained by low inflation coupled with low productivity growth, so nominal wage growth is going to be low.

Are you worried about the flattening of yield curve?

So I always, again, take a step back. Yes, there is a correlation between, in the past, the slope of the yield curve and growth — as a recession predictor. But you have to ask yourself, what is the cause of that correlation? So usually it is because the Fed is aggressively raising short-term rates because inflation has gone up and we have to get inflation back down. … We want to stay with the economy as the economy continues to [exhibit] above-trend growth [and] as we continue to have inflation move to about 2% [and] as we continue to have labor-market strength. … And also, in this current period, I think the signal may be less than in past periods just because, remember, one of the things we did to address [the 2007-08 financial crisis] was to buy long-term assets precisely to put some weight on risk premium on the long end. Everyone likes simple rules and simple correlations, but I think you have to ask yourself, what causes the correlation? And that’s why I’m less concerned than some, probably, about that.

So the quantitative tightening that is going on — how do you think it’s proceeding? Is it impacting the economy at all?

So far I think it has gone very smoothly. I think one of the decisions that was made strategically was to make sure that we were able to extricate ourselves but in a way that would not be disruptive. That would basically run in the background. That would gradually on a slow pace reduce the size of the balance sheet. So far it seems to be going smoothly.

Is it too slow?

I mean, it is what it is. We decided that this is the pace we are going to do. It is not too slow in the sense that we also have the interest-rate tool too, which is our main policy tool. So to my mind those two things working in tandem seem to be working fairly well. The economy seems to be in a good place [and] we’ve been able to move our policy in a way that seems appropriate given the outlook. So it is not interfering one way or the other with the main policy tool we have, which is interest rates.

What is the ultimate size of the balance sheet you would like to see?

I do want us to have that discussion sooner rather than later, because I think it would be good to clarify which operating framework we are going to use. In any case, the balance sheet will be smaller than it is today — even if we decide we are going to stick with the floor system, we’re going to have to reduce the balance sheet. The floor system is simpler; you don’t have to spend a lot of resources in estimating a downward-sloping reserve curve and demand for reserves, and then set your open-market operations so that you have the right supply to hit the target. On the other hand, there are political economy issues in the sense that if you can operate monetary policy with any size balance sheet you are more subject to requests at times to buy assets that wouldn’t necessarily be assets you want to purchase because ultimately we don’t want to do credit evaluation — we want to buy sort of the broadest [market], Treasurys, because it is the farthest away from allocating credit.

In any case, the other thing you have to think about is the funds-rate market, and that market has changed since the crisis in terms of who is supplying reserves, so we may have to think about what our target rate is as well when we are thinking about that framework, so, again, I think it is good for us to have that discussion as a committee, but I haven’t made my mind up which of the two. I think there are pros and cons of each.

Another debate is about the tools to combat the next recession. Do you like the 2% target as it is?

I have to say the bar is high to move off of flexible inflation targeting for the simple reason that, one, I think it has been effective, and, two, I also think we haven’t had experience even globally with these alternatives. That said, I do believe we have to be prepared for a low-interest-rate environment for a long time and this is a good time to be asking these kinds of questions about how would we actually implement a change, whether the change would actually work the way we think it would work, whether there are ways we could stick with inflation targeting and maybe change the way we communicate about it — maybe that’s enough. The idea about a range versus a point estimate.

All of those discussions happened when the Fed selected its target in 2012 and came up with the explicit target. This is not a new thing to be talking about. But I think we need to really do the hard work of assessing those. I don’t think it would be a good idea to just willy-nilly change to a different thing because in theory it works better. We understand conceptually why price-level targeting may give you the room and commit you to keeping rates lower for longer, and maybe that would be a good thing, but I still think there are going to be implementation issues that we really need to work through.

I kind of am persuaded by the Bank of Canada, [which] every five years reassesses their inflation target. It takes them five years to do it because they start with sort of a conference where they bring in external people to talk about these things, and they do a lot of hard work before they come up with their proposal of where they want to be. And I think that is something the Fed should do before they make major changes. But I also think it is something we should be thinking about because we want to make sure that we have tools.

Are you comfortable doing quantitative easing again?

I am comfortable that QE is in our toolbox. If we got into a state where we knew we were hitting the zero lower bound, then I would be comfortable doing QE again. Because I think it worked, and I think that it’s one of the tools we have at the zero lower bound.

Does the wider federal deficit make it harder to do QE?

I think the deficit outlook means that more burden is on monetary policy. When you have both tools, monetary and fiscal policy, you’re in a better position to actually address these kind of issues. But if the deficit remains in this unsustainable state, it is going to be harder for fiscal policy and then more of the burden is on monetary policy. So that is another consideration when you are thinking about how we should be doing monetary policy in the future.

How do you assess financial-stability risks at the moment?

You hear anecdotal things about some behaviors. There is some search-for-yield behavior going on. But I don’t see those risks as being significant at this point, and I also think the financial system is more resilient now than it was. But I do think that we need to keep in mind those kinds of risks, and over time they do build up if you don’t set your policy correctly with what’s going on in the economy.

The most recent Case-Shiller report showed that home prices are up at a 6.8% annual rate. What do you think about that?

I think it depends on, are markets overheating or not? And I think at this point there is no evidence that they are, in a global sense, overheating. There is some work that suggests that supply-side constraints are affecting some of this pricing, so it’s not this huge demand that is necessarily driving up prices. It is basically demand relative to supply because it’s hard to find workers, and some of the construction people have told us it’s hard to find people, and so [builders’] prices are going up in terms of that, and that is affecting home prices. But to my mind we haven’t seen the kind of excess demand that we might have seen earlier.

And the banking system?

I think so far the banking system is healthier than it was, certainly pre-crisis. The work has been done to make it more resilient. Capital levels are up. So far delinquencies are at low levels.

Is the regulatory pendulum now swinging back in favor of looser standards?

I think the principle that should guide all of this is we want to basically have the regulation match where the risks are. And so some of the changes being proposed and implemented are about right-sizing it, so we don’t overburden the community banks, where arguably they are less risky, and take our eye off the large banks. Community banks are important; they add value to the economy, they play an important role, but we don’t want to get into a situation we got into before. So I view what is going on now as trying to do a better job calibrating the regulation and supervision to where the risks are. I would be worried if it was [to] turn back everything that we built up in terms of making higher capital levels, and better liquidity. I don’t see that happening yet. I certainly don’t think the Fed is going there. I think what we’re trying to do is make things right-sized. But I think that is something we need to be attuned to.

The Fed has countercyclical buffers in its toolkit. Wouldn’t it be prudent to put that in place now?

The Board of Governors makes that determination. It is one of the tools that we have. But what the Fed has come out and said about it is, one, there will be lots of notice, I think banks have a year to react to it, and any change would be a gradual change. So, again, I think that’s a good tool for the toolkit. I think it is not a panacea in terms of being able to control these kinds of cyclical risks. Your question is in terms of, do you want to build those buffers up in good times? So you’re right — you can make an argument that this is good time, so should we be building it up? But I still think the focus in the U.S. on how to make the financial system more stable is to really think about resilience and these higher capital levels and liquidity standards, stress tests, living wills — I think that is kind of where the focus should be.

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