The Federal Reserve is widely expected to take the momentous step of raising interest rates for the first time in nearly a decade when it meets later this month. But the decision is likely to be just the first step in a long process of unwinding the unprecedented stimulus the nation’s central bank has pumped into the economy.
The Washington Post spoke with Cleveland Fed President Loretta Mester in an exclusive interview about what she plans to say at the meeting, the bar for future rate hikes and why she’s worried about the rhetoric on Capitol Hill.
The transcript has been edited for length and clarity:
Washington Post: Let’s start with the obvious question, which is December. From your previous speeches, it sounds like you’re pretty much ready to raise rates. How do you plan to weigh in?
Mester: We have about two weeks to go. We’re going to of course look at the data that comes in over those two weeks. But my read of the data is consistent with what I send in my speech a few weeks ago: The economy can handle an increase in interest rates.
My forecast is for growth to be at or above trend, for there to be some further improvement in labor markets, and I’m reasonably confident that inflation will move up to our target in the medium run. Those are the two criteria that the Fed put into its statement in October. I think those criteria up to this point has been met.
Although everyone’s focus on liftoff, it’s really the path of interest rates thereafter that matters. The projection is what drives financial market investors and also the public in terms of their consumer spending and businesses in their investment decisions. That path will be a gradual path. I would say that our expectation and my expectation is that monetary policy will remain accommodative for some time to come. But, of course, we’re going to respond to incoming information.
WP: What is the definition of gradual at this point in time?
Mester: I think the best communication device of gradual is to look at the Summary of Economic Projections. One of the things that I think has been a good addition to our communication devices has been that economic projection package and the so-called “dot plot.”
By the end of 2018, [the dot plots are] back to what the median long-run fed funds rate is. When the Fed says a gradual path, that’s the context I mean. We’re below what we think is the long-run level of the fed funds rate.
We suffered this very, very deep shock to the economy which caused a lot of dislocations in the economy. Many, many people lost their jobs. Inflation went down. Households had to rebalance, deleverage. It just has taken a long time for that recovery to come. In those circumstances, holding interest rates low was the appropriate thing to do.
Now, as the economy has made a lot of progress on those fronts. Now it’s time to work back interest rates above that. But there’s still some of those headwinds: the global economy, the effect on the dollar, which is having a negative effect on manufacturing. Low oil prices, which are a great thing for consumer spending, have also been a drag on the oil sector. Those things are going to continue, but they’ll lesson over time. The expectation at this time is that it will be appropriate to raise interest rates, but only at a gradual pace.
WP: How long have you been ready?
Mester: I think in the summer. I started saying that I think the economy can handle it. But of course, you get shocks after that. In September, we had some of the turmoil in the financial markets. At that point in time, I understood why the committee made the decision it did.
[But] one of the things that I think is striking about the economy is that despite the depth of the shock that hit it, if you look at growth, the progress we’ve made in labor markets, it’s been pretty resilient against some of these subsequent smaller shocks. I’m always saying you can’t just move on one particular data point. You really have to look at what’s the progress that’s been made over time.
Some people were more concerned in late August/September than I probably was. What I’ve learned over time is that it’s easy to get a short-term focus. I think for monetary policy you always have to be thinking about the time period over which policy works. What’s the outlook over the medium-run? Is the economy being resilient?
If you look at the pattern of GDP growth this year, it’s pretty volatile over quarters. But if you look at how the economy has fared, we’ve been running at 2 ¼ percent if you average. Those things are suggestive to me that we have some momentum going into next year.
WP: You said the economy can handle a rate increase. But does the economy need a rate increase? Is there an urgency to you to moving now?
There are a number of considerations to balance. If the data comes in as I expect it to do, I think that it’s appropriate to raise interest rates by 25 basis points. My own view is that we’re at or nearly at full employment now. If you continue to keep interest rates at zero, the risks to financial stability -- although I don’t see them being a big risk now -- I think they grow over time.
The counterargument would be can the economy handle it? If you move interest rates, are we going to stop the recovery? Are we going to stop the expansion? I don’t see it.
WP: What is the bar for the second hike?
Mester: I don’t think you can point to one particular data point, and say OK, if we see that we’re going to raise interest rates. But if the economy continues to grow at or above trend, if we get confirming evidence that the realized inflation rate and also expectations and our forecasts for inflation are still on track -- in other words, if the incoming information is consistent with our forecast -- then I think the path that you see in the SEP is very consistent with the expectations of the committee.
WP: Chair Yellen’s recent speech said there should be no expectation that the Fed will move in a stairstep manner. But there seems to be an implied pattern of movement. I’m wondering if the process of the taper showed that once you start a pattern, the bar is very high for deviating from a set pace that you may or may not have intended.
Mester: I’m taking your questions as perhaps one of the negatives of the [SEP]. You’re showing people what your current thinking of the path is and that makes it harder later on to deviate from that path. I don’t look at it that way.
We are going to respond to economic developments. It’s appropriate for policy to respond to economic developments. Nobody is saying this is the path that will be followed. This is our current thinking, given what we’re forecasting for the economy.
To me, I think the public is knowledgeable on this. We can always at the Fed do better at explaining ourselves. What does it mean to be data dependent? What it means is if incoming information deviates from our outlook, we will respond as appropriate. We’re not committing to do something that would then be counter-productive.
Obviously everyone likes certainty. But they wouldn’t like it if we ran inappropriate policy just because we’re sticking to our guns. People would be better off if we always set policy in order to be appropriate policy.
WP: You’re on the communications subcommitee. How would you rate Fed communications over the past year as we inch toward the moment of liftoff? What do you think is going to be important about how you communicate post-liftoff?
Mester: Improving communication is a journey that the Fed has been on for a long time. It is pretty remarkable that we’ve actually taken a lot of steps over the past 20 years to really improve the way that we communicate.
But there are some things that are unknowlable. You don’t want to simplify things so much that people get the wrong impression.
WP: How do you view this moment, both for the Fed and for the economy? There are two ways it can be described and maybe both are simultaneously true: Is this the Fed’s vote of confidence in the recovery? Or is the Fed saying we’ve done what we could, and tHis is what we’ve got?
Mester: We’re nearly at full employment and we’re reasonably confident inflation will move up to 2 percent. That’s a good thing. The Fed views the economy as on its path to meeting its monetary policy goals. That’s the way I would look at that.
WP: As you think back over the past seven years, what would you say the big lesson or lessons have been and is there anything you would have done differently?
Mester: The actions that the Federal Reserve took prevented the Great Recession from becoming another Great Depression. You can pick apart any little action that was made, but if you look at where we could have been and where we ended up, and if you look at how the U.S. economy is faring at the moment compared to other economies, you have to say that we’re in relatively better shape. I think a lot of it can be attributed to the leadership of the Federal Reserve. The actions, unprecedented as they were, were a net positive.
WP: So when the next crisis hits, as it evitably will, what lessons from this period will you apply?
I think we’ve learned some of the costs and benefits of zero interest rates. You do have to take seriously financial stability issues. We don’t really have the framework yet, and the theory, the micro-foundations and the macro-foundations are still unknown. We have progress, but we don’t fully understand them.
Hopefully, we’ve learned enough to try to lower the probability of these events. But as Fed Vice Chairman Stan Fischer said, you always have to be prepared. Hopefully, we’ve learned something about the pros and cons of each of these tools. There’s no panacea.
Whatever form the next event that happens takes, it probably isn’t going to be the same as the past.
WP: What do you see as the biggest risk as the Fed embarks on this process of tightening? Is there a mistake you’re determined not to make?
Mester: Some of the risks are external to the Fed -- political economy things going on now. Dodd-Frank restricted some of the things the Fed did with its [emergency lending powers], which probably is very appropriate. But now there’s calls to limit [those powers] even more. I find it interesting and a little problematic because I think people have forgotten the history of why the Fed was established in the first place: It was established because of the financial crises in the early 1900s. This lender of last resort functions of the Fed is one of the quintessential reasons you want to have a central bank.
Having a central bank that can lend on good collateral is a good thing. I think about the independence of the Federal Reserve in terms of everyday decisions on monetary policy. We don’t want that to become interconnected with politics. I’m all for Fed transparency and accountability. I’m all for the Fed Chair having to testify to Congress and explaining monetary policy rationales. I don’t think it’s a good idea to try to inject short-term politics into monetary policy positions. Those are the sort of things from a structural point of view that worry me.
WP: Are there any provisions in either the bill passed by the House or the Senate bill that you would support?
Mester: I don’t want to go point by point down the bills. I just worry about the tone and the trend that this gets to. Even the name Audit the Fed gives the impression that our financial statements aren’t audited, we’re not held accountable, etc. I just think that’s not true.
WP: What do you view as the role of dissent within the Fed?
Mester: I personally thing the diversity of views is a productive thing within the Federal Reserve system. We actually end up with better policy.
I would be more worried at this point if everyone had exactly the same opinion. Because then I would say, we’re missing something. If you’re not constantly questioning, if you start believing yourself all the time that you’re right, that gets you into trouble.