At the invitation of JRCPPF Undergraduate Associates, Loretta J. Mester *85, President and CEO of the Cleveland Fed, gave a public talk on Monday, March 27th at Princeton University. In addition to discussing the economic outlook, Mester assessed labor market conditions, the expected path of inflation and the monetary policy agenda. She expressed optimism on the future growth of the U.S. economy but also pointed to uncertainties introduced by recent trade policies.
Mester expects economic growth to surpass the 2.5% rate of 2017 fuel by expansionary fiscal policy, healthy consumer spending and a moderately paced housing sector recovery. Global economic growth should also have a positive effect via exports but "the tariffs on steel and aluminum imports and ... planned tariffs on certain goods imported from China, as well as the ongoing renegotiations of the North American Free Trade Agreement (NAFTA), add uncertainty to the trade picture."
Mester indicated her support for continued gradual interest rate hikes for this year and next, "... a gradual upward path of interest rates will help sustain the expansion and balance the risks..... 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."
Mester ended her remarks with two future monetary policy considerations: on the operating framework that the FOMC uses to maintain its policy rate and on the monetary policy framework that the FOMC uses to determine the appropriate policy rate. Mester noted that before the financial crisis, the FOMC achieved its federal funds rate target by making small changes to the supply of bank reserves. But, after the Fed's large-scale asset purchases, banks are holding around $2 trillion in excess reserves. So, small changes in reserves have little effect on the funds rate. Now, the Fed achieves its target by adjusting the rate it pays on excess reserves. As the Fed's balance sheet shrinks, which of these tools will the Fed use to achieve its target rate?
Another consideration for the FOMC, noted by Mester, was the issue of what framework should the FOMC use to determine the appropriate monetary policy. Currently, the Fed uses a flexible inflation-targeting framework which recognized that over the long run monetary policy can only affect inflation and not real aspects of the economy such as the natural rate of unemployment, but that it can affect short run economic fluctuations in employment. However, many economists anticipate that the longer-term equilibrium real rate will remain lower that in past decades. This will result in a reduction in the effectiveness of the traditional interest rate tool and force the Fed to resort to less effective nontraditional monetary tools. In light of this, should the Fed adopt alternative frameworks such as targeting inflation higher than 2 percent or targeting a path for the price level or for nominal GDP. Mester argues that these alternatives must be carefully reviewed and the FOMC should start a framework assessment later this year.
The public talk was followed by a private dinner where Princeton students had the opportunity to have a candid discussion with Mester. For some photos of the public event click here and for the private dinner here.