– Risks of Doing ‘Too Little’ Tightening Outweigh Risks of ‘Doing Too Much’
– Won’t Back Slower Tightening Pace Until She Sees Inflation Moving Down
By Steven K. Beckner
(MaceNews) – Despite 300 basis points of short-term interest rate hikes, monetary policy is still not restrictive, and the Federal Reserve needs to keep raising rates to make it restrictive and keep it that way “for some time,” Cleveland Federal Reserve Bank President Loretta Mester said Tuesday.
Mester, a voting member of the Fed’s policymaking Federal Open Market Committee, said the FOMC will need to “weigh the risks of tightening too much,” but suggested the Fed is far from that threshold for now.
Currently, the risks are weighted toward raising rates “too little,” not “too much,” she told the Economic Club of New York, adding that she projected a higher federal funds rate than her FOMC colleagues in September.
Mester acknowledged the Fed faces considerable uncertainty and must take a “cautious” “risk management approach,” but she said caution doesn’t mean the Fed should do less than needed to reduce inflation to the Fed’s 2% target.
Talking to reporters after her speech, she said inflation is “unacceptably” “broad-based” and “persistent’ and said she would not support slowing the pace of or pausing rate hikes until inflation starts moving lower. So far, she said she’s seen little or no progress.
Mester joined in a unanimous FOMC decision on Sept. 22 to raise the federal funds rate by 75 basis point for the third straight meeting to a target range of 3 to 3.25%. At the same time, FOMC participants upwardly revised their funds rate projections in the Summary of Economic Projections (SEP) dramatically to a median 4.4% by the end of 2022 and to 4.6% by the end of 2023.
“The FOMC is committed to taking appropriate action to tighten financial conditions by raising the fed funds rate and continuing to reduce the assets on the Fed’s balance sheet in order to return the economy to price stability,” she said in prepared remarks.
“Monetary policy is moving into restrictive territory and will need to be there for some time in order to put inflation on a sustained downward path to our 2% goal,” she continued. “We will be looking at a variety of incoming data and collecting economic and financial information from our business, labor market, and community contacts to help guide our policy decisions.”
Mester said “we will need to continue to weigh the risks of tightening too much against the risks of tightening too little,” but “given current economic conditions and the outlook, in my view, at this point the larger risks come from tightening too little and allowing very high inflation to persist and become embedded in the economy.”
“As the effects of tighter policy work through the broader economy, I expect my view of the balance of these risks will shift, and I am looking forward to that time because it will mean that we have made meaningful progress on the transition back to price stability,” she added.
Referring to Nobel Prize winning economist Milton Friedman’s famous statement that monetary policy works “with long and various lags,” Mester suggested that dictum needs to be taken with a grain of salt and not be interpreted as meaning the Fed can go slow or pause its rate hikes in the current environment.
“It is unlikely that we have seen the full effects on households and businesses of the latest rate increases we have implemented and it would not be appropriate to continue moving rates up until inflation is back down to 2%,” she said. “But it is also the case that based on Fed communications, financial conditions began to tighten well before our first rate increase in March and those effects have been passing through to the economy.”
“Yet high inflation persists, an indication that we need to increase rates further,” she went on. “In order to put inflation on a sustained downward trajectory to 2%, policy will need to move into a restrictive stance. That means that short-term interest rates adjusted for expected inflation, that is, real interest rates, will need to move into positive territory and remain there for some time.”
Since the FOMC started raising the funds rate from near zero in March, it has raised it by 300 basis points, but Mester said “policy is not yet restrictive.”
FOMC participants estimated the longer-run nominal fed funds rate, a proxy for the “neutral” funds rate, at 2.5%. Mester said that “means that if inflation were 2%, and inflation expectations were well anchored at levels consistent with that goal, a real fed funds rate of half of a percent would be neutral in the sense of neither stimulating nor restraining economic activity.”
But she said “that is an important if.’ Currently, inflation and shorter-term inflation expectations are well above 2%. If we adjust the current nominal fed funds rate by the SEP median projection for inflation next year, which is 2.8%, policy is still a tad accommodative.”
So, she said “further funds rate increases are needed to get policy into a restrictive stance. But she questioned whether the September median funds rate projections of 4.4% by the end of 2022 and 4.6% by the end of 203 would be adequately restrictive.
“Because I see more persistence in inflation than the median SEP projection, the funds rate path I submitted for the September SEP was a bit higher over the next year than the median path, and I do not anticipate any cuts in the fed funds target range next year,” she said.
Mester emphasized she “will adjust (her) views” if the economic outlook changes. “While it is clear that the fed funds rate needs to move up from its current level, the size of rate increases at any particular FOMC meeting and the peak fed funds rate will depend on the inflation outlook, which depends on the assessment of how rapidly aggregate demand and supply are coming back into better balance and price pressures are being reduced.”
The outlook could be affected by a variety of factors, including international and financial developments, she said.
Mester conceded the Fed “will be operating in an uncertain environment for some time,” but said that need not mean being excessively cautious and “acting inertially.”
“(I)n the current environment of high and persistent inflation, a risk management, robust control approach counsels that being cautious does not mean doing less,” she said. “Instead, it means being very careful to not allow wishful thinking to substitute for compelling evidence, leading one to prematurely declare victory over inflation and pause or reverse rate increases too soon.”
“It means not being complacent that inflation expectations will remain well anchored in this high inflation environment but taking appropriate actions to keep them anchored,” she added.
Echoing Fed Chairman Jerome Powell and others, Mester stressed the importance of keeping inflation expectations “anchored” and welcomed the fact that so far they have been contained, but she warned, “every month that inflation remains highly elevated raises the chances that inflation expectations will become unanchored and that firms and households will begin to make decisions based on persistently high inflation.”
“If that were to happen, returning to price stability would be more difficult and much more costly in terms of lost output and higher unemployment,” she said. “Even if one doesn’t think an unanchoring of inflation expectations is the most likely scenario, the costs of being wrong are high given the current state of the economy.”
“So the robust control approach encourages strong action to keep expectations anchored to prevent the worst-case outcome from actually occurring,” she continued, adding, “in the current environment, being cautious means that the FOMC should persevere in taking policy actions to return the economy to price stability.”
Elaborating on her monetary policy views in a media availability session, Mester put strong emphasis on the need for the FOMC to see progress in reducing inflation before considering taking a less aggressive tightening course.
“My read right now is that we still have very high inflation, and we have not seen any progress really on inflation…,” she said. “We need to see progress (against inflation) before we need to be shifting.”
“I don’t see the signs I’d like to see on the inflation front” to justify a less vigorous monetary tightening strategy, Mester went on to say, adding that “the risks of allowing inflation to persist at this level are very high.”
Asked her criteria for slowing the pace of rate hikes, she replied, “I want to see some of those monthly readings come down,” and also wants to see better “forward readings.”
“What’s going on with inflation that is most troubling is that this is broad-based, not just commodities …,” she said. “I want to see some better numbers there .… Given the level of inflation, its broad-based nature, its persistence and the costs of allowing it to continue.. and disrupt the stability of inflation expectations I would like to see that start moving down.”
Mester declined to say what size rate hikes she might support at coming meetings, saying “it’s going to depend on the whole panoply of data .… I don’t want to make a decision before the (Nov. 1-2) meeting.”
“In my mind, I do think the risks are still to the side of not doing enough,” she went on, adding, “at some point as inflation comes down my risk calculation will shift.”
At that point, she said, “I will want to either slow the rate of increases or hold for awhile,” but she reiterated “at this point my concern is more on (the side of) we haven’t seen progress on inflation,. We’ve seen some moderation, but we need to go farther.”
Responding to a question from MaceNews, she said her recommendations for the path of the funds rate will depend most heavily on the inflation outlook.
She said her funds rate projection in September was “just a tad higher (than other FOMC participants) because I see inflation not coming down as much next year as the median.”
“So I would say we have similar paths in the sense that rates have to go up form the current level a little bit, and then we hold there next year in order to get inflation on that downward path back to 2% by 2025,” she continued. “I would say there’s a lot of consistency across members of the FOMC at this point, and that’s driven by those inflation readings we’re getting that are still unacceptably high.”
As for what rate levels she might advocate at future FOMC meetings, Mester said, “as we go forward, of course, we’re going to be always looking at what is the incoming data and economic information that we’re getting from our contacts are telling us about where the economy is headed, and if it turns out that inflation comes down much faster than I’m anticipating today then of course I will be using that information to inform where I think policy needs to be calibrated.”
“On the other hand, if inflation doesn’t come down and we see that the pressures are still increasing then will help me evaluate where policy is as well,” she continued. ‘So you can’t say today where the economy is necessarily going to be, but the factors that are going to matter are what is the inflation outlook — where is inflation currently and where is it going. That’s going to inform the policy path.”
In other comments, Mester said the Fed is “monitoring” financial stability risks and vulnerabilities, but said that at present “I don’t see any big pending risks out there.”