MNI INTERVIEW: Fed Prepares To Hike On Sticky Inflation-Mester

The division of opinions within the FOMC on the direction of U.S. monetary policy reflects uncertainty rather than complacency and will only be resolved as new data accumulate, former Federal Reserve Bank of Cleveland president Loretta Mester told MNI. 

Roughly half the committee has penciled in rate increases this year while the other half favors holding. If underlying inflation fails to decline as the Fed's own forecasts project, policymakers will have little choice but to raise rates, she said. 

"They do have an inflation problem," with services ex-housing stubbornly high even before the Middle East oil shock, Mester said in an interview. "You can make a case for holding pat until we gain some more information, but if you continue to get reports that do not show the underlying inflation rate coming down, then you're going to have to tighten." 

Mester cautioned against finding too much comfort in stable medium- and longer-run inflation expectations, saying they remain anchored only because markets expect the Fed to deliver on price stability. Should expectations begin to drift higher, the committee would find the inflation fight considerably harder to win, she said. (See MNI INTERVIEW: Fed Could Soon Lean Toward Rate Hikes-Giannoni)

CASE FOR WAITING

Standing pat also carries its own risk, because it would amount to an implicit loosening of policy as real rates fall, she said. The committee waited too long to respond to rising prices after Covid, and growing supply-and-demand imbalances ultimately required more aggressive tightening than would otherwise have been necessary.

"Kevin [Warsh] has said we're going to get back to 2% inflation. Well, they need to tell us how they're planning to do that. Is it just waiting, because somehow you think the combination of oil prices coming down coupled with AI lowering prices eventually through productivity will help? We don't know what they're thinking of." 

The labor market is also complicating the committee's calculus, Mester said. Some officials view a low unemployment rate as evidence of resilience, while others attribute it partly to falling labor-force participation, an argument that could support a longer pause.

"If you wanted to say the labor market's probably not as strong as the unemployment rate suggests, and therefore that's another reason to wait, I think you could make that argument." (See MNI INTERVIEW: Fed Could Be Easing Before Year-End-Kroszner)

TASK FORCES 

Mester said she was encouraged by the caliber of leaders selected for Fed Chairman Kevin Warsh's new task forces to reexamine the conduct of monetary policy -- a group comprised of scholars, central bankers and business leaders with a diversity of views.

With regards to the balance sheet task force, co-led by Karen Dynan, Raghuram Rajan and Jeremy Stein, Mester said she expects the group to dissect the trade-offs of the current ample reserves system and perhaps to create a clear set of principles on how to distinguish asset purchases to support market functioning from those intended to add accommodation -- a distinction the Fed itself failed to make during the pandemic, she said. 

"All central bankers, having gone through the financial crisis and the pandemic, have been rethinking the costs and benefits of QE," she said.

Rajan is likely to focus on the risk that an oversized Fed balance sheet crowds out private-sector risk management, a view that aligns with Warsh's own thinking, while Stein has historically favored maintaining ample liquidity, she said.

On the communications task force, which includes former Bank of England governor Mervyn King, Mester said she expects recommendations to center on how the Fed conveys its reaction function conditional on the economic outlook and better mechanisms for signaling the diversity of views among committee members, potentially including changes to the dot plot. 

She doubted that declining to discuss the rate outlook as Warsh did in his June press conference was sustainable. 

"First, the Fed owes us some information and transparency about how they're thinking about the economy," she said. "Secondly, if we don't hear from the chair, then he's allowing others to drive the conversation. I don't think that's probably a very good way of leading."