Loretta Mester: The costs of stopping tightening too early are high
This is part of a series, ‘Economists Exchange’, featuring conversations between top FT commentators and leading economists
At no point since the 1980s has the Federal Reserve moved with such force to cool down the world’s largest economy. Confronted with stubbornly high inflation and the looming threat that it will become even more deeply rooted in Americans’ lives, the US central bank has since March ratcheted up its benchmark policy rate from near-zero to nearly 4 per cent.
Loretta Mester, president of the Fed’s Cleveland branch, played an instrumental role in shaping this strategy as one of 12 members of the Federal Open Market Committee in 2022, who vote at eight regularly scheduled gatherings convened throughout the year on decisions related to interest rates and the central bank’s $8tn-plus balance sheet.
Officials assemble for their final policy meeting of the year in mid-December, at which they are expected to end what has become a months-long string of supersized 0.75 percentage point interest rate increases as they have struggled to catch up to price pressures they initially misdiagnosed as more fleeting in nature.
Mester — who assumed her position in 2014 and will next serve as a voting FOMC member in 2024 — and her colleagues are poised to begin slowing the pace of rate increases while simultaneously doubling down on their commitment to do whatever is necessary to get inflation back down to their longstanding 2 per cent target, even as recession fears percolate and political pressure to back down builds.
In this discussion, she unveils what she wishes the Fed had done differently this year, how much more the central bank may need to squeeze the economy and what’s at stake if it fails to get inflation down soon.
Colby Smith: I’m curious as to what surprised you most this past year about the economy. What do you wish the Fed had done differently?
Loretta Mester: Well, the inflation forecasts were off. We thought inflation was going to start moving down this year and in fact it moved up and has become more persistent and more broad based than I think many forecasters — including some at the Fed but also in the private sector — expected. So my concerns about inflation and the upside risks came to fruition, unfortunately, and inflation was much higher than I had expected it to be.
In terms of what could we have done differently, it’s probably true that we could have started raising rates before we did, because we actually pivoted our discussion about interest rate increases in the outlook for policy before we made the first fed funds rate increase in March. Part of that was because we wanted to make sure we were not surprising the market, but were explaining why we were doing what we were doing.
That said, financial conditions began tightening before that first rate increase in March, which of course then impacted the economy before the actual increase.
The other thing that we could have done is we could have stopped buying [bonds]. It took us a while to slow those purchases. That last month or two of purchases, once we realised policy was going to have to tighten, we didn’t need to keep doing that. But we were following the playbook from the last time, and then it was very important that we signalled what we were doing well in advance. That was the reason we did what we did.
Now, of course, the balance sheet is falling, so we did get there.
These are all learning situations. One thought experiment is, would it have made that much difference to where we are now? I don’t think so. It might have started tightening financial conditions before they actually did tighten, but they also started tightening well before the first rate increase. So it’s hard to say. But I think there are going to be some lessons to take forward as we think about monetary policy.
CS: Obviously the Fed has done quite a bit this year to right some of these wrongs and catch up to a certain extent, and there’s far greater unease about doing too little to combat inflation than doing too much. Which way do you see the risks tilted, given that the front-loading phase of this tightening cycle appears to be drawing to a close?
LM: Given where we are in terms of inflation readings, the outlook and the risks, I still put more weight on a higher risk or a higher cost of not doing enough. We know that allowing inflation to be as high as it is and allowing that to continue, it has costs on the economy today, but it also imposes costs on the economy tomorrow.
To be so far away from price stability really distorts investment decisions and peoples’ investments in their own education, and that has implications for the long-run health of the economy. If we allow inflation to continue at high levels, inflation expectations could start moving up again in the long-run horizon. And that would then raise the cost of getting back to price stability.
So it’s really imperative that we don’t allow any of those things to happen and that we err on the side of making sure, before we do anything and declare victory over inflation, that we’ve got a lot of evidence that inflation is beginning to move down on that sustainable path towards 2 per cent. That’s where my calculus is.
I do believe inflation is going to move back down next year, and I expect my risk balance is going to change. That would be good, because it would mean we’ve actually made material progress on inflation.
I do think we’ve had some pretty welcome news on inflation. The October consumer price index report was good news — there is evidence of goods prices stabilising and moving down. There’s even some good news on rents in terms of new leases being signed, at lower levels. We can’t really read too much into that at this point except to be happy — we can’t really take our eye off the fact that we’ve got to do more to bring inflation down.
CS: Is there anything in the data that points to elevated inflation becoming more entrenched? That, yes, we might see the rolling over that you just mentioned next year but also we’re settling at a higher level?
LM: Well, if you look at inflation expectations — and we all know that you have to look at a lot of different readings, not just one indicator — the short-run expectations have moved up. Research tells us and the evidence shows us that consumer expectations of inflation over the next year move up with some salient prices like gasoline prices and food prices.
Gasoline prices have moved down and when that happened we saw short-run inflation expectations move down, but they still remain elevated. On a longer horizon, inflation expectations have not moved up as much. That’s a good thing — it suggests that they’re better anchored. And it’s imperative that we don’t allow them to move up. That’s why I’m really focused on inflation.
I don’t think we can take the anchoring for granted. The longer inflation remains high and the longer near-term inflation expectations remain elevated, the greater the risk that those long-term inflation expectations could become unanchored and move up, and then that helps sustain high inflation and gets into wage and pricing behaviour. That just makes it much more costly to return inflation to our goal.
I’d like to point out to people that we really need price stability if we expect to have healthy labour markets in the long run. So I don’t think of this as an either-or, I think that if we’re going to support both sides of our dual mandate, we have to get back to price stability.
CS: On the process by which inflation does come down and where the Fed could get a bit of help, vice-chair Lael Brainard recently expressed hope that higher inventories will unleash competitive pressures among businesses to reverse mark ups. And that would initiate a reduction of margins that she argues could meaningfully help reduce inflationary pressures in some consumer goods. Do you share that view?
LM: Well I think there’s a number of factors that might get inflation down. So goods prices is one. We know that housing-related costs are pretty sticky. but the new lease news that they’re moderating is a good thing. And mark-ups are high in a lot of businesses, so the competitive side Brainard is talking about would be a factor as well.
I think monetary policy has a lot to do with getting inflation back down. So we’re going to have to keep at it for longer to make sure all those factors continue in the right direction.
There’s also risk on the upside of a shock. There could be higher price pressures on natural gas given the war in Ukraine. There is a lot of risk out there, but I’m hopeful.
My forecast is that we will see meaningful progress on inflation next year. We won’t be back at our 2 per cent goal for some time — maybe towards the end of 2024. But we’ll see enough progress to keep long-run inflation expectations anchored and that means we could get back to 2 per cent inflation with lower pain to the economy than otherwise.
But we are entering a new phase of policy, because we have basically brought the funds rate up to what I think is the beginning of a restrictive stance and we’re moving into the restrictive territory that is necessary in order to get inflation on that sustainable downward path to 2 per cent. So we’ve made progress, and now we just have to continue on the journey.
CS: Right, but what specifically do you consider compelling enough evidence to, let’s say, consider pausing the rate rises? And how does that compare with the threshold for cuts?
LM: I don’t think we’re near a pause. Given we’re beginning to move into restrictive territory, we have the opportunity to slow the pace of increases and evaluate the effects and make sure we’re being very diligent in setting monetary policy to return the economy to price stability, but also judicious in balancing the risks to minimise the pain of the journey back to price stability.
We had one good October CPI report. I would need to see several more of those and more moderation and perhaps even a reduction in core services prices. And we also have to see better balance in the labour market.
Right now there are signs that labour market conditions are moderating on the demand side, but we still have pretty high wage pressures. We need to have more evidence confirming that things are moving in the right direction.
It’s very easy to be caught out by the good news, but we don’t want wishful thinking to take [the place of] really compelling evidence. The costs of stopping too early are high. We want to be very diligent about this.
CS: One concern that is often raised is that focusing so much on a lagging indicator like realised inflation all but guarantees that the Fed ends up going too far. What is your response to that, and how are you incorporating other forecasts into your assessment of whether the Fed has done enough?
LM: That’s an excellent question because we often say we’re data dependent, and when I use that term I don’t just mean the statistical releases that come out of the official government, because you’re exactly right, they do tend to lag. What I do mean is including the up-to-date surveys that we do — the Cleveland Centre for Inflation Research runs weekly surveys that actually ask consumers about inflation expectations.
And then we do a lot of outreach in our district to community development organisations that really assess what’s going on in the labour market and wages and to business people in all sectors, manufacturing and services, to understand what they’re seeing and also how they’re thinking about their own wage bills. So there’s a lot of forward-looking information that we incorporate in the way we forecast.
It’s a balance of the official statistics but also the evidence from our surveys and others that are much more timely and have much high frequency data, [including] financial market conditions data, as well as anecdotal reports. That information is really crucial, and tells us where the economy is going in terms of inflation and employment.
CS: At the last meeting on monetary policy, the Fed emphasised the notion of policy lags and taking those into consideration when thinking about future interest rate adjustments. Fed chair Jay Powell mentioned that newer economic literature suggests policy lags may actually be significantly shorter than initially thought. Do you subscribe to that view? And how have those dynamics influenced your thinking about how far the Fed needs to go?
LM: I think there’s two things going on. It could very well be that the dynamics have changed, partly because we’re communicating much more about our policy views and the rationale. We did see, for example, mortgage rates react very quickly when the FOMC and the chair began pointing people to the fact that we’re going to have to tighten monetary policy.
That could be a sign that the economy reacts more quickly or it could just be that we’re communicating earlier and giving forward guidance about where policy is going. It means that the starting point isn’t really March when we did our first rate increase. It was in the fall last year, when the committee started saying, “Hey, we’re moving into a different regime and a different policy setting and we’re going to be tightening policy and reducing accommodation, and then moving interest rates up”.
So it’s difficult to read whether it’s really the dynamics that have changed or communications have changed, leading to the economy reacting faster.
Be that as it may, it’s true that if you take the start point being what the media call the “pivot” in the fall last year, we’ve been tightening for quite a while and yet we haven’t seen inflation move down appreciably yet. That means we still need to bring interest rates up from current levels, but as we go we’re going to be gaining more information and that will tell us how high they ultimately have to go.
We do recognise — as we always have during policy tightening cycles — the fact that there are lags in monetary policy. We have to be cognisant of that and of the fact that inflation has been very stubborn and it’s very broad-based and it’s going to take time to get it down, and we need to stay on the job until it is back down. So I think that’s where the committee is.
CS: The communication point is playing out in real time because the overarching message we hear right now from the Fed is that even as it prepares to slow the paces of rate increases, the terminal rate will probably need to be higher than was expected just a couple of months ago. And in that vein we heard from your colleague, president James Bullard in St Louis, who recently referenced the Taylor Rule in his discussion about how high rates need to rise. He said that formula suggests fed funds may need to go as high as 7 per cent, which is obviously well above market pricing and officials’ forecasts.
So how significantly do you incorporate those kinds of principles into your thinking about the appropriate levels of rates? And is a benchmark policy rate of 7 per cent in the realm of possibility?
LM: I’ve never ascribed to the fact that we should just pick a rule and follow what it tells us, because the economy is much more complex than our models. But they’re informative in terms of what the range of possibilities is. The key thing is we have to bring interest rates up and there is a uniform view of the committee that we need to do more.
As we go forward and determine what is the appropriate policy, then we’re going to be doing that judicious assessment: are we seeing inflation rates move down at the right pace so we’ll get back to price stability in a timely way or are we going to have to bring rates up higher than we anticipated?
I can’t tell you exactly today how much it will take. We know we’re going to need to move the rate up and we probably need to hold it at a high level for some time before we bring it down.
CS: Is there a level of interest rates at which you would be a bit more nervous about financial stability risks and the need to incorporate that into your thinking as well?
LM: We’re always attuned to financial stability risks. If you look at the financial stability report that the board of governors put out earlier in the month, it goes through the calculus of where there is vulnerability. Certainly a fast pace of interest rate increases does pose, in the abstract, a risk to financial stability. We’re cognisant of that possibility, but so far markets are functioning. There’s a few pockets of liquidity being constrained in the Treasury market and that’s something we’re monitoring.
The situation in the UK, that’s an example of a shock, if you will, that happened. The market was sceptical about the fiscal package that was put out by the government. We saw a very sharp increase in gilt yields and that precipitated some dysfunction and potential unrest in financial markets — a real financial stability risk.
We haven’t seen that in the US, but I think it’s something that we have to take as a cautionary tale. We’re engaged in a real battle in terms of making sure we can get inflation down.
CS: Shifting to the economic outlook, many economists expect the US economy to tip into a recession next year with unemployment potentially eclipsing 5 per cent. But you’re much more optimistic it seems. So what are they missing?
LM: The recession risks have increased, no doubt. And my forecast is that we’re going to have growth well below trend over the next couple of years and when you’re in that very low growth environment, a shock could easily push growth into some negative numbers. We already saw two quarters of negative growth this year.
But the labour market continues to be very strong. It could easily be that we see slower growth but we don’t see the kind of increase in the unemployment rate that usually accompanies that type of slow growth, because the demand for labour has been so much outpacing the supply.
There’s a lot of risk surrounding the outlook and there are shocks that could come from multiple places. The Chinese economy is one place, with the new Covid policies again tightening up, that might affect supply chains as well as demand. We know the war in Ukraine is not done yet, and that might have implications. We know growth globally is slowing. So there are many factors out there that would affect our economy, but what’s been remarkable about our economy over the past three years is how resilient it’s actually been.
CS: To what extent does that resilience make your job harder? Because when we do get stronger-than-expected data coming in, it seems like the initial reaction is always that the Fed is just going to have to do more to cool things off.
LM: That could be what the reading is, but there are many scenarios that could play out. I’m not trying to underplay that this is a painful journey. This is not going to be necessarily smooth. We know that there’s been high volatility in financial markets that is hard for both households and businesses to navigate.
We know that unemployment will probably have to go up somewhat. For the people affected, that is going to be painful. But high inflation is really painful, too. People who are less well off in terms of households and businesses, they’ve really had to struggle through this.
We shouldn’t underestimate the consequences of that high inflation continuing, and now we’re just trying to do our best to get back to price stability at minimum pain. But this is a fight that’s worth fighting because we just can’t keep the economy at the current level of inflation without harming the economy over the longer run.
CS: Well, where we’ve started to see some of that initial pain is in the tech industry, where week after week we’re hearing about substantive lay-offs. And I’m just wondering at what point you would be concerned that these lay-offs are in some way a harbinger of a broader deterioration to come across the labour market?
LM: I wouldn’t necessarily focus on one particular sector as being the harbinger, because remember, the tech sector also benefited in some sense from what happened during the pandemic. It’s less of a forecast of the economy really slowing down, but we need to keep our eye on those things to make sure we aren’t seeing a broader slowdown. Certainly some of our business contacts suggest that they still see very strong labour markets, but are seeing some of the open positions move down. So you’ve got to look at the lay-off data, but you also have to make sure that you don’t read into one sector and extrapolate that to the whole economy.
CS: Have you given up in some way on getting any help in terms of increased labour supply, which would mean you have to do less on the demand front in the job market?
LM: I have not for some time been expecting a big influx of labour supply once we saw that the prime age participation rate had moved back to its trend rate. The trend is down because of demographics. I wasn’t really expecting to see this great inflow of people who had left the workforce during the pandemic because a lot of those were retirees and they typically don’t come back in large numbers.
And also, immigration continues to be low and I don’t see that changing any time soon. We may see some increased participation in the labour market, but I think much of what has to happen has got to be done on the demand side.
CS: So looking at the optimal outcome for the Fed: if inflation is settling above the 2 per cent threshold this time next year and getting it back down to 2 per cent is going to potentially cause significantly more economic pain, and much more material job losses as well, how willing is the Fed to make that sacrifice?
LM: We’ve never operated policy that we expect everything to be pinpointed at one particular number. It’s basically a long-run goal.
I take the 2 per cent goal very seriously, and I do think we’ll get back down to 2 per cent. But you’re right, we have a dual mandate. And so when we get down to where it’s clear that we have brought the economy back to price stability, then we’re going to be able to make those kinds of decisions.
But at this point, we’re very far away from that and so we’ve got to just stay focused on and set policy to getting inflation sustainably back on the path to 2 per cent. I look forward to when we’re going to be in a position when we can have those trade-off decisions, in terms of where does policy need to be to meet both sides of our dual mandate? But right now the price stability part of the mandate dominates.
The above transcript has been edited for brevity and clarity