- Mester Sees Liftoff ‘By End Of Next Year’; Worse Inflation May Mean More
- George Wants to Raise Rates ‘Sooner Rather Than Later’
- George Cites Financial Stability Risks As Key FOMC Concern
By Steven K. Beckner
(MaceNews) – Kansas City Federal Reserve Bank President Esther George and Cleveland Fed President Loretta Mester agreed Friday the time has come for the Fed to start making monetary policy less stimulative.
George and Mester, both of whom will be voting members of the Fed’s policy-making Federal Open Market Committee next year, made clear they think that in the near future the Fed should start scaling back the aggressive asset purchases it has been doing since March of last year to hold down long term interest rates.
They expressed less urgency or certainty about raising short-term rates, but strongly suggested they don’t want to delay “liftoff” beyond next year.
The two women spoke two days after the FOMC took a significant step toward tapering asset purchases.
The FOMC said Wednesday a reduction in bond buying from the current $120 billion per month pace “may soon be warranted,” assuming the economy continues to make “substantial further progress” toward its employment and inflation goals as expected.
Chairman Jerome Powell appeared to set a low bar for “tapering,” saying the FOMC “could easily move ahead at the next meeting.” He told reporters, the maximum employment test has been “all but met” and said he only needs to see a “decent” September employment report, not a “knock-out” one.
Although Powell described the likely pace of tapering as “gradual,” he said the process would likely be concluded by “around the middle of next year.”
The FOMC left the federal funds rate in a zero to 25 basis point range, but half of the 18 FOMC participants now project at least one rate hike by the end of 2022, and the median projection for the end of 2023 is 1.0%.
Based on their comments it seems likely George and Mester were among those wanting “liftoff” to begin next year. In the past, they have expressed concern about elevated inflation and financial stability risks, and they reprised those warnings Friday.
George and Mester concurred that the FOMC’s standards for beginning to scale back asset purchases have been fulfilled.
“In my view, the criteria for substantial further progress have been met, with inflation running well above our target and the unemployment rate at 5.2%t, down 1½ percentage points relative to December,” George said in a webinar hosted by the American Enterprise Institute. “Under these conditions, the rationale for continuing to add to our asset holdings each month has waned, and signaling that we will soon consider bringing our asset purchases to an end is appropriate.”
Meanwhile, Mester said “the economy has met those conditions, and I support starting to dial back our purchases in November and concluding them over the first half of next year.”
They were less emphatic about liftoff.
As the FOMC reiterated Wednesday, it “expects it will be appropriate” to keep the funds rate in a zero to 25 basis point target range “until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time. “
Echoing Powell, Mester told the Ohio Bankers League “the start of asset-purchase tapering should not be taken as a signal that the FOMC plans to raise the fed funds rate any time soon. Even after tapering starts, our balance sheet will be growing and monetary policy will remain very accommodative.”
While the standards for tapering have been met, the tougher test for raising the funds rate has not as yet, George and Mester concurred, though the latter sounded more inclined to start raising the funds rate before the end of next year.
Mester said “inflation developments suggest that the second condition has largely been met…,” but said the employment condition “has not been met.”
“The economy is still some distance from maximum employment,” she continued. “The number of payroll jobs and the labor force participation rate are still well below where they were prior to the pandemic, and unemployment rates are still well above their pre-pandemic levels.”
However, Mester added, “as the recovery continues, labor markets will continue to improve, and I expect that the conditions for liftoff of the fed funds rate will be met by the end of next year.”
Mester suggested the FOMC may have to tighten policy – either through faster tapering or rate increases more aggressively than the latest “dot plot” implies. Seeing “upside risks to inflation … as outweighing the downside risks,” she said “if elevated inflation readings were to persist longer than anticipated and inflation expectations were on a trajectory to move higher than levels consistent with our 2% goal, monetary policy would need to be adjusted in order to bring inflation and inflation expectations back to our 2% goal on a sustained basis.”
George also seemed fairly eager to make policy less stimulative. Responding to questions, she said she thinks monetary policy should be firmed “sooner rather than later.”
“We could be low for long, but I don’t want to be lower for longer any longer than we need to be,” George said. She agreed with former Council of Economic Advisors Chairman Jason Furman’s comment that monetary policy is now “very, very, very accommodative”; that after tapering it will remain “very, very accommodative,” and that after liftoff it will still be “very accommodative.”
George took a more nuanced approach in prepared remarks. “The ongoing effects of these asset purchases, alongside the presence of both upside and downside risks, will complicate the task of judging the achievement of criteria for raising rates.”
“One might argue that today’s inflation dynamics are likely to keep inflation moderately above 2% for some time and align with the Committee’s threshold criteria,” she elaborated. “On the other hand, the criteria for judging maximum employment are murkier.”
“While it is clear that we remain far from the historic low levels of unemployment achieved pre-pandemic, it is less clear to me that such a benchmark will be the best guidepost in the current expansion,” George added, explaining that “the pandemic introduced a number of frictions into the labor market.”
“Barring further intensification of the virus, I would expect these frictions to fade, promoting strong job gains and a relatively fast approach to maximum employment,” she said. “However, I am open to the possibility that the pandemic has resulted in a number of structural changes in the labor market.”
George said “these (labor market) changes could affect the assessment of maximum employment in ways that are not yet clear.”
Like Mester, George spoke of upside risks to inflation. “A sustained step down in inflation is likely to also require a stabilization in services prices,” she said.
Responding to a question about “asset bubbles,” Geroge also reiterated her longstanding concern, as a former top bank supervisor, about threats to financial stability, noting that the Fed’s last Financial Stability Report “pointed to a number of vulnerabilities” and “stretched valuations.”
“That is always the case when you have accommodative policy,” George said, adding that “financial stability is an absolute condition for being able to achieve (the Fed’s) objectives.”
Looking past tapering and liftoff, George suggested the FOMC will face some tough longer run challenges for monetary “normalization.” She said policymakers will need to decide how large a balance sheet they want to sustain after tapering has ended and calculate the appropriate “neutral” level of the funds rate relative to the balance sheet.
“Beyond interpreting the evolving economic landscape, policymakers also must consider the implications of the multiple policy tools at play as we contemplate removing policy accommodation,” she said.
“While the shift from extraordinary policy accommodation to policy normalization remains some way off, the linkages between balance sheet policies and the path for policy rates will be factors in future policy deliberations,” George went on.
The Fed has purchased more than $4 trillion of securities over the past year and a half, pushing its total asset holdings to nearly $8.5 trillion.
“All else equal, maintaining a larger ‘normal’ balance sheet should imply a higher “normal” terminal policy rate, as higher policy rates are needed to offset the stimulative effect of the balance sheet’s continued downward pressure on longer-term interest rates.”
George said several factors could affect policy settings. ‘(O)ne question that might be considered is where along the yield curve would we prefer the most policy space: at the long-end or at the short-end? If the zero lower bound is thought to be a costly constraint on policy, there might be an advantage in pushing towards a higher neutral policy rate, arguing for maintaining a relatively large balance sheet weighted towards longer-maturity assets.”
“The accommodation provided by our balance sheet in this case will have to be offset by higher policy rates, which in turn would provide us with more space to cut rates in a downturn,” she said.
“We might also want to consider the rationale for a smaller balance sheet, or at least shifting toward one with shorter-maturity assets, with a lower neutral policy rate,” George continued. “One rationale might be a desire to decrease our footprint in financial markets.”
George said another consideration for the FOMC might be the slope of the yield curve.
“Raising rates while maintaining a large, long maturity balance sheet is a recipe for inverting the yield curve, with potential negative effects for traditional banking models,” she warned, adding that “an inverted yield curve is a particular headwind for community banks, promoting further consolidation in the sector and undermining the critical role that community banks provide in terms of local access to credit and economic development.”
Just as recovery from the pandemic “is likely to confound our assumptions about what a return to normal might look like,” George said “the same is true for the monetary policy normalization process. Both point to a long and difficult process ahead as the economy heals and the stance of monetary policy responds.”
Responding to questions, George said the FOMC faces a “particularly high level of uncertainty” as it tries to assess the economy and make policy. Given the unreliability of forecasts, she said the FOMC must consider “the cost of being wrong.”
George indicated she does not favor changing the composition of Fed purchases of agency mortgage backed securities and Treasury securities. “My owns sense is that these two asset types have been part of the mix for some time” and that the FOMC should “not pivot toward trying to affect credit allocation.”