Cleveland Fed President Mester: Flat yield curve does not signal weakness

Cleveland Federal Reserve President Loretta Mester has joined the chorus of Fed officials trumpeting hawkish views. Note her comments about financial stability and reloading the Fed’s interest rate gun. At the margin, these variables further promote a tightening bias at the Fed. At the same time, Mester is now discounting a flattening yield curve, which makes the Fed’s tightening bias even more acute.

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Cleveland Federal Reserve President Loretta Mester has joined the chorus of Fed officials trumpeting hawkish views. Reuters is reporting that she does not see a flattening yield curve as a market signal of economic weakness. So, this gives the Fed a green light to hike rates irrespective of the steepness yield curve.

Loretta Mester in line with Yellen on the yield curve

Now, Mester’s view on the yield curve itself doesn’t represent a policy shift at the Fed. She made similar comments about the yield curve in December. Then-Fed Chair Janet Yellen said much the same in December of last year as well. See my comments on those remarks here. What is notable is that, when Yellen and Mester made their remarks in December, the yield curve was pricing in less than two rate hikes for 2018. Now, the market has moved beyond three hikes for 2018 to speculating on four. So the regime shift under new Chairman Jerome Powell has been fully absorbed by the market.

Moreover, let’s also remember that Bernanke famously disregarded the yield curve as a late-stage economic signal when he was Fed Chair back in 2006. And he used his “global savings glut” thesis to make that case. I see Mester’s comments on the yield curve as in line with Bernanke’s. The difference is that she posits it from the perspective of central banks accumulating dollars. Bernanke talked of the source of that accumulation coming from private sector savings and current account surpluses. But, realistically, the savings glut and the central bank dollar accumulation come from one and the same source. However, note that the first article in my links post showed Wall Street strategists predicting dollar accumulation weakening.

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Notable Mester views on inflation and employment

Here’s exactly what Mester said on inflation and employment, the Fed’s dual mandate:

  • On the unemployment rate being below the non-accelerating rate of unemployment: “I recently moved my own estimate of the longer-run unemployment rate down by 1/4 percentage point, to 4-1/2 percent. I expect the unemployment rate to move below 4 percent this year and to remain below 4 percent next year. Overall, my assessment remains that from the standpoint of the cyclical conditions monetary policy can address, we are slightly beyond the maximum employment part of the Fed’s monetary policy mandate.”
  • On 2% inflation as a target, not a ceiling: “The FOMC has set a symmetric goal of 2 percent inflation, as measured by the year-over-year change in the price index for personal consumption expenditures, that is, PCE inflation. “Symmetric” means that the 2 percent inflation goal isn’t a ceiling; the FOMC would be concerned if inflation were running persistently above or persistently below this goal and such persistent deviations warrant a policy response.”
  • On the primacy of inflation as a Fed mandate: “Another consideration for the FOMC is the framework it uses to determine appropriate monetary policy. Currently, we use a flexible inflation-targeting framework. This framework recognizes that, over the longer run, monetary policy can influence only inflation and not the underlying real structural aspects of the economy such as the natural rate of unemployment or maximum employment, but that monetary policy can be used to help offset shorter-run fluctuations in employment from maximum employment. I believe this framework has served the FOMC well and has been effective in promoting our policy goals. It has been the choice of many central banks around the globe.”

Mester on the US and global economy

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I think the following comments from Mester are key in thinking about how the Fed sees its role.

  • On headwinds turning to tailwinds: “Last year, economic growth picked up to 2-1/2 percent, and I expect growth to be a bit above that pace this year and next. This is an improvement from the average 2 percent pace over prior years of the expansion. In addition, growth is now more balanced across sectors….Indeed, for the first time in many years, economic activity around the world is picking up and forecasts for global growth are being revised up. This should have a positive feedback effect on the U.S. economy via exports.”
  • On how fast the Fed will proceed: “Given the economy’s strength, we don’t want to get behind the curve, but we also don’t want to overreact to the positive outlook and potentially curtail the expansion. This takes some careful balancing, and in my view, last week’s decision on rates reflects this type of balanced approach to achieving and maintaining our policy goals.”

Mester on other reasons for the Fed to tighten

  • On the irrelevance of quantitative tightening: “But now, as a result of the Fed’s large-scale asset purchases, reserves are very abundant: indeed, banks are holding around $2.2 trillion in reserves in accounts at the Fed, and about $2 trillion of this amount is in excess of what is required by regulation. At these levels, small changes in the supply of reserves have little effect on the fed funds rate. Instead, the Fed brings the fed funds rate into its target range by adjusting the rate it pays on excess reserves.”
  • On the Fed’s hiking to reload its ammunition and to promote financial stability: ” In addition, a gradual upward path of interest rates should help avoid financial imbalances and a potential build-up of financial stability risks that could arise from the extended period of very low interest rates. And it puts monetary policy in a better position to address whatever risks, whether to the upside or to the downside, are ultimately realized.”

Concluding thoughts

Mester’s comments support the view that the Fed wants gradual rate hikes but now has a tightening bias. That means that the Fed is calling for three rate hikes in 2018 in eight FOMC meetings. But to the degree inflation rises, wage growth rises or unemployment falls more quickly than expected, we should expect four rate hikes to become official guidance.

Most notable here is the fact that Mester sees unemployment below a longer-term sustainable level. That suggests she will look for accelerating wage growth as a sign of inflation. And this would cause her to recommend an accelerated rate increase timetable.

Also note her comments about financial stability and reloading the Fed’s interest rate gun. At the margin, these variables promote a tightening bias at the Fed. However, Mester is now discounting a flattening yield curve. That makes the Fed’s tightening bias even more acute.

Source: The Economic Outlook, Monetary Policy, and Some Future Considerations for the Monetary Policy Agenda, Cleveland Fed

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