Loretta Mester, president of the Federal Reserve Bank of Cleveland, joined Yahoo Finance to discuss her outlook on inflation and the central bank's response.
Below is a transcript of her appearance, aired live on May 10.
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BRIAN CHEUNG Welcome back to Yahoo Finance. I'm Brian Cheung here live on site at the Atlanta Fed’s Financial Markets Conference in beautiful Amelia Island and I'm here with Cleveland Fed President Loretta Mester. President Mester, so it's great to see you and also in person for the first time.
LORETTA MESTER: Exactly, thank you for having me on.
BRIAN CHEUNG: So nice to be here in Florida. To kick off this conversation just about Fed policy, or obviously the big move happening last week with the Federal Reserve raising interest rates by 50 basis points, in your view, what's the next steps for the Fed?
LORETTA MESTER: Well, we have to get inflation under control. And that means moving the interest rate up. We have to move it up at a pace that will get that inflation under control. By under control, I mean, turning down, right? So looking at the monthly numbers and seeing that it's actually moving back down. And that'll be a challenge, no doubt. Because there are a lot of things that are affecting inflation now on the supply side that aren’t really affected by monetary policy. But we’re really committed to be doing what we need to do with our policy tools to get demand better in line with that constrained supply and inflationary pressures.
BRIAN CHEUNG: What underscores the need to move is the fact that we got an interest rate bump in a size that we haven't seen since May of 2000. I'm wondering if you feel that more outsized bumps would be needed? Is it on the table for a 75 basis point hike in the future?
LORETTA MESTER: Well, there's always something on the table, right? And, you know, [Fed Chair Jerome Powell] in the press conference said that he was comfortable with, you know, moving in another couple of meetings at 50. I'm certainly comfortable with that. I think we're going to have to be very careful of evaluating whether we’re actually seeing that inflation move down. So we'll do the next couple of meetings. If things stay the way they are looking now. I think 50 at the next two meetings makes perfect sense. We’re going to have to then evaluate whether we either have to speed that up — if you don't see inflation moving back down — or if we see demand coming down faster than we expect it to, we might be able to go a little slower but we’ve gotta be committed to that inflation, those inflation numbers down.
BRIAN CHEUNG: There is kind of a lag effect to monetary policy, right? So it's not necessarily the case that you're going to see the impact of a 50 basis point increase last week immediately. So I guess, is your view— we're still seeing inflation numbers come in high. We're getting another print on the Consumer Price Index tomorrow. When would you expect to see the impact of these Fed hikes on inflation?
LORETTA MESTER: Yeah, well this is the thing. I'm gonna need to see compelling evidence that inflation is moving back down. I know there were a lot of reports in the press with the last report that: ‘Oh, wow. It moved a little bit down.’ That's not compelling evidence to me. I don't want to move this too quickly off of this upward path. We need to get monetary policy in a more neutral stance, and then we have to evaluate how much further beyond that is going to be needed to move that inflation needle down. And it's going to be challenging, no doubt. Because there are things going on on both the supply side and the demand side. But the risks to inflation remaining high get even more risky as we keep going, because of inflation expectations/ So it’s really important we’re committed to doing what we need to do.
BRIAN CHEUNG: You mention neutral. For our viewers, that's kind of an estimate of where the Fed might want to get interest rates to on the short term end where it's neither stimulative nor restrictive to monetary policy. What is your estimate what that is right now, the current target rate is between 75 basis points and 100 basis points on the short term rate? What's your estimate for how the Fed needs to get there?
LORETTA MESTER: On a nominal basis, I've been saying around 2.5%, is what I write into that [Summary of Economic Projections]. But again, you know, we might have to go above that if we want to get inflation down and we are committed to getting inflation down. Again, we don't have to make that determination today. But that upward path out and my own SEP, I think we're gonna have to go beyond neutral to actually rein in inflation, but I'm open to looking at how things evolve over the second half of this year and into next year to be able to make a more precise estimate of what that will look like.
BRIAN CHEUNG: And I guess, how far you might have to go above neutral is a bit of a precarious situation because you also don't want to tilt the economy into a recession. What do you see as the risk of recession right now, especially one that might be induced from this tightening policy?
LORETTA MESTER: I mean, there's no doubt that the challenge for the Fed is a large one, right? I think things will be bumpy, we've seen that in financial markets now as financial markets are adjusting. And it may very well be that the unemployment rate will have to move up a little bit. We may get another quarter of negative or slow growth, but that's going to have to happen if we want to get inflation back down. So I'm comfortable with that. I don't think what we're planning to do with monetary policy, at least in my base case, is going to push the economy into a downturn. That's a sort of a staying downturn. We’re aiming to get inflation down and sustain conditions for an expansion. And I don't really see it as a trade off really, because I really fundamentally believe that if you don't get back to price stability, we're not going to have sustainably healthy labor markets in the future.
BRIAN CHEUNG: And I want to get back on the labor markets in a second. But I mean, you mentioned an interesting point, we could see another quarter of negative GDP given the fact that we already had a negative surprise on Q1 GDP. Two quarters back-to-back might constitute a recession — in some definitions. I know we're in a room full of economists, they will tell you that there are a lot of caveats to the two quarters of back-to-back negative growth for classifying something as a recession. So is that not the best metric for determining what would be a hard landing from the Feds perspective?
LORETTA MESTER: Yeah, I mean, I don't look at it as like two consecutive quarters, although you're right, that's kind of a rule of thumb. If you actually look at the underlying data in the first quarter. If you looked at both consumer spending and business spending. There's a lot of positive momentum there right? The things that held back first quarter were: trade, government spending. That inventory correction, a little bit, because inventories were built so much in the fourth quarter. So if you look at that report, and look under the hood of it, there's a lot of still positive momentum in demand. And that's why it's important for the Fed to be raising rates, right? We're trying to bring demand into better balance with that original constrained supply and that constrained supply given what's going on in China with the zero-COVID policy and Ukraine — the war in Ukraine, which is terrible. Those things have the potential of being upside risks to inflation even if they pose some downside risks to growth.
BRIAN CHEUNG: So on the point of I guess, assessing what could be, you know, the impact of higher rates? Do you also expect, you know, the unemployment rate to go up given — if there's gonna be this pullback in demand that's induced by higher borrowing costs — is that going to hurt the labor market?
LORETTA MESTER: Well, we might see, you know, a couple of months of that going back up, but again, I don't think that's going to be sustained right? The labor markets now are in a position where there's so many more openings than people looking for positions. And so it's out of balance. And so what we're doing with at the Fed is trying to rebalance the economy and there's just excess demand in both product markets and labor markets and we can push that down. Yes, there could be a case where the unemployment rate goes up for a couple of months, there could be a case of another negative quarter of GDP growth because it is, you know, there's a lot of things moving at the same time, but our intention is to get inflation under control, and to have a sustainable expansion be the outcome.
BRIAN CHEUNG: So let's talk about financial conditions right now. Things are volatile. We’ve seen a lot of red across equity markets in the past few trading sessions, over the last few months really. Are financial conditions as tight as you'd like them to be through these hikes?
LORETTA MESTER: Well, we’re trying to raise the short end — our policy rate. And of course, how does that affect the economy? It affects it through financial market changes. And so what we're seeing is: our moves, coupled with a lot of other things going on in the global economy , affecting the financial markets. But the intention is to tighten financial conditions to get that inflation moving back down. You know, we don't look at day to day changes in the financial markets and having that be our driving force. We're really focused on our dual mandate goals of price stability and maximum employment.
BRIAN CHEUNG: Were you surprised to see financial conditions actually loosen in the initial response to the announcement last Wednesday and the press conference?
LORETTA MESTER: So I never really can predict how it's going to come out on that first day. I think what I like to look at is: okay, after the market absorbs the actions and the signaling from the words in the statement, how do they settle out? And you know, this is just a very, very uncomfortable position, right? In terms of volatility in the markets, etc. But it's a necessary situation that we have to go through in order to get those inflation numbers down.
BRIAN CHEUNG: Almost forgot to talk about the balance sheet. Of course, a big topic. The announcement last week that that process is going to begin June 1 to let some assets roll off of the Fed’s holdings. When it comes to that process, it seems like there could be some flexibility in the future if needed. Would you see a situation where the Fed might want to actively sell some of its holdings to maybe shrink it at a faster rate than was charted out last week?
LORETTA MESTER: Yeah, I mean, I actually think we need to consider selling to somebody [mortgage-backed securities] at some point during the process because one of our principles is to get our portfolio to be primarily Treasuries. And the reason that's important is because we don't want to be influencing, you know, credit markets. And so, you know, I think that's something we should consider. And if you looked at the minutes to our March [Federal Open Market Committee] meeting, we actually said that there seemed to be general agreement on the committee that we should be looking at that in the future.
BRIAN CHEUNG: Is there a size that you would like to get the balance sheet back to? I mean, 4.5 [trillion] was kind of where it was before the pandemic. Ballooned to almost 9 trillion. I guess, reserves that are going to be kind of the target or guiding path?
LORETTA MESTER: Exactly. That’s going to come in the future, as we get closer it. And as the Fed announced, we'll be ratcheting down and sort of going to a glide path. But we won't know that until we get closer as we kind of monitor conditions. We're in an ample reserves regime, and we're going to make sure that we're holding enough reserves to be in that regime, to stay in that regime, but not overly large on the balance sheet. And so we'll know more as we get there. It's going to depend on the banks’ demand for reserves and the distribution of reserves across financial institutions, and that'll determine that.
BRIAN CHEUNG: And then last question before I let you go and enjoy the beautiful sun here in Florida. There's a financial stability report that came out yesterday. I'm just wondering kind of how you're viewing overall financial stability conditions. What's interesting is that through the volatility, and the report didn't really necessarily toucH on specifically this, but the broad issue of stablecoins and then perhaps being subject to runs. We saw one small stablecoin, Luna and Terra, kind of have issues over the past few days. Is this something that presents a financial stability concern in your view, from the central bank’s view?
LORETTA MESTER: I think we have to be looking at the longer-run underlying structures of some of the markets. Stablecoins are one of them. I think the Treasury market, our experience at the beginning of the pandemic really underscored that there's some structural issues there. Money market mutual funds, again. And those are the kinds of things that I think we all need to be working on. And it's not just one entity. It's not just the Fed. It's not just Treasury. It's a large group of regulators and overseers to really make sure that we have resilient financial markets. It's not about getting rid of all volatility. It's making sure that institutions and participants are resilient to shocks that can come from anywhere.
BRIAN CHEUNG: Right, Cleveland Fed President Loretta Mester live here at the Financial Markets Conference in Amelia Island, Florida. Thanks so much for joining us.
Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.
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