"We need to further normalize our monetary policy"
Interview with Loretta J. Mester, President and Chief Executive Officer, Federal Reserve Bank of Cleveland
Ms. Mester, the US is enjoying the second longest economic recovery of all time. How long can this last?
In my opinion, the US economy is currently doing very well. The labor market is really strong, personal incomes are rising and the sentiment among businesses and consumers is very good. Investments are also picking up for one year now, which is also positive. Growth has thus become more balanced. It is not all dependent on consumers. All this indicates that the upswing can continue for some time. That does not mean that there are no risks. But the economic outlook is perhaps the best we've had in a long time. The economy is experiencing a sustained expansion.
So worries about a looming recession, which are increasingly coming up not least because of the sheer duration of the upswing, are exaggerated?
The duration of an upswing alone does not say anything about whether it is sustainable or not. We should also not forget that our monetary policy is still accommodative, even though we have reduced the degree of monetary accommodation over the couple of years. Added to this is the fiscal stimulus provided by the tax package and higher government spending. That’s an additive to the economy but the timing and magnitude are uncertain. For this and next year I expect 2.5% to 2.75% growth. I see the potential rate at around 2%. So I expect growth above potential and I see the risks as balanced. For me, all of this means that we must continue to carefully adjust our monetary policy.
The worries of many experts also stem from the very flat yield curve, i.e. the small gap between short-term and long-term interest rates. An inverse yield curve has often been a signal for a recession in the past. Are you not worried?
It is true that in the past there was a correlation between the structure of the yield curve and the probability of recession. But we need to consider why. You have to distinguish between correlation and causality. Just because the yield curve is flat does not necessarily mean lower growth or even a recession. There are a number of good reasons why the yield curve is currently flat. On the one hand there are our asset purchases. These were explicitly intended to lower risk premiums and long-term interest rates. On the other hand, inflation has been fairly low, below our 2 percent target. Finally, there is a great demand for US bonds as a safe asset. All this pushes long-term interest rates down.
So no need to worry?
I would be worried if the low long-term interest rates had to do with the fact that economic agents expect less and less growth. But that's not the case when looking at surveys and forecasts. The yield curve is not inverted, and I am not overly concerned with the shape of the yield curve. I also think that there is a likelihood that long-term rates will be lower than in the past. This is due to the demographics and the demand for safe assets. Of course, the budgetary situation in the US could cause an increase in risk premiums in the long run. But all together, demographics will push down long-term interest rates in the longer run, and we have to take this into account in our monetary policy.
Before we come to monetary policy - where do you see the biggest risks for your optimistic growth outlook? Is this the trade dispute, not least between the US and China?
The trade dispute is creating uncertainty and this could be a burden on the willingness to invest. However, many surveys and the discussions we have with entrepreneurs directly suggest that this risk has not yet materialized. They stick to their investment plans. However, that can change and we have to keep an eye on it. How the tariffs actually affect depends on what is decided exactly in the end. The steel and aluminum tariffs are quite limited and there are exceptions for some countries and regions. But an escalation of the trade dispute and a tit-for-tat-policy would certainly be bad for the US economy.
But so far this is not a reason for the Fed to change course?
No, in my view, so far the trade disputes are no reason to change course and slow down normalization. As I said, the trade dispute is a potential risk. But I think we should not change course on this because of a risk, but wait until we have more clarity on how things evolve.
Do you see any danger that the US economy is overheating? Many experts fear this, not least because of the fiscal stimulus in an already fully utilized economy.
It is very uncertain and difficult to predict when and how the fiscal stimulus will affect the economy exactly. But I do not think that the tax package and higher spending will bring a very large boost to growth, although it is an upside risk. Many companies have already been optimistic before and have planned investments, and this only reinforces or confirms this optimism. But we have to remain vigilant also in that case: If the fiscal stimulus is reflected more than expected in the willingness of companies and consumers to spend and in growth, we may have to steepen our policy path somewhat more than previously thought.
But you are currently not worried about an overheating?
I think we are making progress towards our two goals of price stability and full employment. I do not see that the economy will overheat in the foreseeable future or that inflation could suddenly pick up. However, in my view, given the current positive outlook, I believe we should continue gradually reducing monetary policy accommodation. On the one hand, we do not want to be too aggressive, because inflation has not yet reached our goal. At the same time, on the other hand, the labor market is very tight. At 3.9%, unemployment has even fallen below a level many monetary policy makers see as full employment. Many companies tell us that they are increasingly finding it difficult to find qualified workers. That's why they are already paying more bonuses and raising wages. It's only a matter of time before wage growth will pick up more strongly. So we have to balance inflation and the job market.
The Fed’s most favored inflation measure, the PCE deflator in the core rate excluding the volatile energy and food prices, most recently was at 1.9%. That's not far from the target of 2%?
First of all, it was a big challenge to bring inflation back towards the 2%. Over the past few months, inflation has risen and this can continue for a few more months. After that I expect a slight weakening of the rates. However, looking at the general trend, inflation is picking up gradually and is heading towards the 2% target. In my opinion, inflation will sustainably reach 2% over the next one to two years. Over the next few months, inflation may temporarily jump above the 2% mark.
The International Monetary Fund even warns that US inflation may suddenly pick up more than expected, and that the Fed may have to tighten monetary policy more aggressively than expected. But you do not see this danger?
No, I do not expect to see inflation rise sharply and that we would have to counteract aggressively in a preventive way. This is contrasted by the inflation dynamics at the moment and by stable inflation expectations. Inflation expectations play a key role: After the great recession, there was the potential for deflation. But inflation expectations remained fairly stable as businesses and consumers had confidence that central banks would do whatever was necessary to keep inflation stable. This has contributed significantly to preventing deflation. This credibility also works in the other direction. There is no reason to overreact when inflation temporarily exceeds 2%.
To what extent and for how long can the Fed tolerate an overshooting of the 2 percent target? Is that not a dangerous game with inflations expectations?
What matters is that we are completely transparent about what our goals are, and that we explain exactly why inflation is evolving in the way it does. There is a short-term potential for higher inflation rates. Oil and commodity prices are rising and factors that have recently dampened inflation are falling out of the statistics – for example with cell phone data plan prices. Beyond this short period, however, inflation could ease off somewhat, but still on an upward path to 2 percent. I do have some concern that if inflation rises temporarily above 2%, it could be misinterpreted. If markets say and expect that the Fed must then tighten its monetary policy more aggressively, that could be counterproductive. The markets and the public should neither overreact when inflation is temporarily a little below the target, nor at times when it is slightly above.
Is there anything like a "red line" for the Fed - be it 2.5% or 3% inflation?
That certainly depends on who you ask. But many would not say that they are worried about exceeding this or that level. The decisive factor is the medium and long-term outlook. If inflation is significantly below or above our target for a considerable period of time, then there is a need to act. We do not have to react automatically to temporary deviations. And what is also very importantly here is, our inflation target is symmetrical.
Financial market participants are currently expecting a next Fed rate hike in June, and at least some speculate that it could become four instead of three rate hikes in 2018. Do you feel comfortable with such expectations?
I think market forecasts are in line with the communication the Fed has given, which is also reflected in our projections. We are on a course for gradual rate hikes and we will probably reduce monetary policy accommodation a little further. The question of whether there will be three or four rate hikes in the end is, honestly, rather marginal from a macroeconomic or monetary policy perspective.
But not for financial markets.
That's true. And if market expectations decouple from our message, it can lead to problems. But as I said, I do not see that. Both three and four rate hikes this year would be in line with our policy of a gradual interest rate normalization.
But the pendulum is more likely to move towards a fourth rate hike in 2018 than towards less than three steps?
We need to further adjust and normalize our monetary policy to the rather positive outlook. But we do not want to become overly restrictive in our monetary policy because there is no need for it. Inflation is still below target. At the same time, the labor market is very strong and already tight. If inflation picks up more or if the fiscal stimulus is reflected more strongly than expected, we will correspondingly adjust our policy appropriately. But if inflation does not pick up as expected, that's an argument to wait longer and be more cautious. In the end, everything depends on the data and outlook. And everything revolves around keeping the economy on a sustainable course of expansion.
Since October 2017, the Fed is actively reducing its balance sheet by no longer fully replacing expiring bonds bought under the asset purchase programs. How satisfied are you with the progress of this operation so far?
First of all, we also wanted to make clear that the short-term interest rate is our central instrument. And we wanted to reduce the balance sheet so that it is in terms of both size and composition more "normal" again. We were very transparent and communicated this early on. So far, everything is very smooth. Above all, everything happens in the background - and that was the plan. However, there is still a big open topic on the table and that is the question which operational framework we want to have in the future: Do we want to continue to operate with a very high volume of bank reserves and thus with a larger balance sheet or do we want to return to a system of scarce reserves and a smaller balance sheet?
So the question of a "floor" or a "corridor" system. What do you prefer?
Both have advantages and disadvantages. A system with high reserves and a larger balance sheet is certainly easier to implement. In addition, the Fed funds market has changed dramatically since the crisis and it is not clear whether it would work again as it did in the past. But it is also clear that a larger balance sheet comes with political economy problems. In particular, there is no limit to the size of the balance sheet. At the Fed, we may come under pressure to buy securities that we do not feel comfortable with. It will become harder to say no, if there are no technical limits. Another question is if the Fed Funds Rate is still the best instrument or, for example, if we should target a general level of interest rates. We have to discuss all this intensively and I have not yet made a final judgment. We still have some time, because even a higher balance sheet in the future will definitely be lower than the current level. But I think we have to come to a decision pretty soon.
Would it be easier for the Fed to normalize policy if other central banks such as the ECB moved more decisively to end their own ultra-loose policy?
Each central bank has to decide in its own area of responsibility and based on its own mandate and outlook, but takes into account developments in other economies to the extent that they effect their own economy. It is important that we are all as transparent as possible.
In the US, central bankers are also intensively involved in the debate about fundamental changes in monetary policy, whether it is a question of higher inflation targets or another strategy than inflation targeting - for example price level targeting. Is the time already ripe?
We should have this discussion and we should start it relatively soon because it takes a lot of work to understand all possible implications. Flexible inflation targeting has worked well and has been effective. The bar to change this is high for me. Nevertheless, we have to deal with these questions. I think that we will live in a low interest rate environment for some time and that the neutral equilibrium interest rate has fallen. This suggests that there will be less scope for policy rates to act in an emergency. At the same time, some doubt the effectiveness of broad-based asset purchases and some would prefer these tools not be used. So it can happen that in the future we will reach the lower interest rate bound more often and have less room to move our policy tool. So we should look at all possible options.
And this includes a higher inflation target or price level targeting?
There are a few things that can be done within the current regime of flexible inflation targeting. This includes a higher inflation target or a tolerance band in contrast to a point target. Another option is to change the strategy altogether. Of course, we also have to keep in mind that almost every other central bank has the same strategy. That's another reason why the bar is high. But that cannot mean that it can never be changed. With all this we should not forget one thing: that some strategies have never been done. It may sound good in theory, but in practice there may be problems. So we should not take changes in strategy lightly and precipitately. But for me, it is a matter of good leadership of central banks to step back from time to time and critically question themselves. In the US, it is certainly the right time, because the economy is doing well.
Will broad-based asset purchases or even negative interest rates, as in the case of the ECB, be part of a "new normal" monetary policy?
In my opinion, buying a lot of securities is something you use in exceptional times. There may be situations in the future where they will be used again. Maybe that will happen even more often than before because of the lower equilibrium interest rate. But for me, broad-based asset purchases are and will remain an unconventional tool that is not part of the central banks’ tool kit in normal times.
The interview was conducted by Mark Schrörs.
Loretta J. Mester is President and Chief Executive Officer of the Federal Reserve Bank of Cleveland.