A Diligent Return to Price Stability
Loretta Mester | Episode 104
Loretta Mester joined Markus’ Academy. Mester is president and CEO of the Federal Reserve Bank of Cleveland.
Watch the full talk below and read Mester’s remarks here.
Highlights
[0:00] Markus’ Introduction. Many pressing issues face us today: the inflation anchor, labor tightness, monetary policy, as well as monetary policy’s interaction with fiscal policy, and the international impact of US monetary policy.
[4:15] Recent updates to monetary policy. Last week, the FOMC raised the target range for the federal funds rate by 75bp to 3.75%–4.00% (the fourth 75bp increase in as many meetings). The Fed is also continuing its balance-sheet reduction via runoff. There are more shifts planned for the future, as the inflation challenge is a larger one. This has been one in a rapid set of shifts, increasing 375 basis points this year, but it is warranted due to the current state of the economy. Inflation is unacceptably high at the moment, as a variety of metrics can show. Services inflation has not shown meaningful slowing and inflation remains broad-based (about half of PCE items were ≥5% higher YoY in September). There has been a decline in underlying inflation over the last few months, and the October CPI report suggests some easing in core measures.
[10:56] Labor markets. There needs to be further slowing in both product and labor markets. While there are still challenges, there has been some easing in supply bottlenecks, though the labor market is still tight. We should expect real GDP growth to be well below trend this year and next year. Job gains are slowing, but the number of openings per unemployed person is much higher than it was in the tighter labor market in 2019. Some metrics like the employment cost index suggest that labor demand may be outpacing labor supply, as the year over year percentage change is at 5%, which is too high to maintain price stability. It is hard to tell whether some of the shifts in labor market participation are going to be lasting, overall labor force participation remains below pre-pandemic levels, while prime-age participation is roughly back on trend.
[17:26] Fighting current inflation. The FOMC is very committed to returning to price stability, and current projections suggest that inflation could return to target by 2025. While near term inflation expectations are high, the medium and longer term inflation expectations remain relatively well anchored. It is critical that policy moves swiftly to retain the inflation expectations anchor. Monetary policy is going to need to be restrictive, and remain restrictive for some time in order to keep decreasing inflation levels, down to 2% over time. There are three key considerations for raising interest rates: how fast, how high, and how long. At this point the larger risk is tightening too little, though that risk balance may shift as inflation declines and cumulative tightening works through the economy.
[22:18] Understanding inflation expectations. Metrics used for understanding forecasts and expectations are derived from the official metrics, as well as survey data, and business and labor market indicators that provide forward looking information. Expectations measurement is a signal-extraction problem, we should triangulate across survey and market-based measures rather than relying on a single ‘best’ metric.
[27:29] Need for accurate tightening policy. Growth is likely to be well below trend, Business contacts suggest possible ‘labor hoarding,’ which could limit how much unemployment rises, but unemployment could also rise more than anticipated, with associated hardships. This still may be necessary, in order to combat the harms caused by inflation both today and in the long-run due to a potential lack of price-stability. While this is happening, there needs to be a balance between the risks of tightening too much and the risks of tightening too little. Tightening too little would allow for persistent inflation, and necessitate a much more costly journey back to price stability. The largest risk right now would come from tightening too little, as easing up on the rate hikes would be dangerous if the inflation rate did not adjust as expected.
[32:11] Flexible Average Inflation Targeting. FAIT is not a mechanical, numerical averaging rule and does not change the Fed’s 2% longer-run goal. There can be no strong labor market without price stability in the intermediate and long-run, which means that the primary focus should be on inflation. This framework gives the ability to bring inflation down over time, which could be a more effective means for price stability. It is important to follow a risk management approach. Losing the inflation anchor is more risky than overshooting the inflation target on the downside. The inflation expectations anchor of households is driven by salient non-core inflation numbers, like food and energy price changes, while inflation in normal times is better predicted by core-inflation numbers.
[41:03] The Taylor Principle. The Taylor Principle suggests that the Fed should raise rates more than inflation increases, in order for the real rates to increase. Though there are a wide variety of inflation beliefs, the funds rate is used as the anchor. Bringing the funds rate up will make sure that the inflation rate sustainably decreases. Balance-sheet runoff helps firm the stance of policy, but there is more uncertainty about its effects than for the policy rate.
[53:49] Modern Monetary Theory. Among some policymakers, there was a sense prior to this recent episode that there would not be inflation even with increased fiscal spending. However, Mester does not think any policymakers subscribed to MMT even if it has been a part of the broader public/political discussion. The FOMC remained resolute in aiming for the 2% goal. Monetary policy must aim to address the issues in both fiscal and financial sectors.
[1:00:03] International Impact of US Monetary Policy. The Fed monitors global developments mainly through spillbacks to the U.S. via financial-market and trade channels (even if trade is smaller for the U.S. than for some economies).