While tax reform should boost spending and raise economic growth in the near future, Federal Reserve Bank of Cleveland President Loretta Mester suggested Tuesday three rate hikes would be appropriate this year and next.

"If the economy evolves as I anticipate, I believe further increases in interest rates will be appropriate this year and next year, at a pace similar to last year's," Mester told the Dayton Area Chamber of Commerce, according to prepared text released by the Fed. Last year the Fed raised rates three times in 25 basis point increments.

Federal Reserve Bank of Cleveland President Loretta Mester
Federal Reserve Bank of Cleveland President Loretta Mester Bloomberg News

“I believe this gradual upward path of interest rates will help balance the risks and prolong the expansion so that our longer-run goals of price stability and maximum employment are met and maintained,” she continued. “This policy path gives inflation time to move back to goal while, at the same time, avoiding a build-up of risks to macroeconomic stability that could arise if the economy is allowed to overheat, with the Fed then having to raise rates sharply in response.”

If, however, the economy does not evolve as expected, she noted, the Fed will adjust. “If the upside risks to growth come to pass, we may need to steepen the path a bit; if inflation surprises on the downside, we may need to go a bit slower.”

While Mester expects tax reform to raise spending and lift economic growth in “the next couple of years,” she said, “it is difficult to be precise about the magnitude of the effect of the fiscal stimulus from the tax changes,” but her estimate is it will add “1/4 to 1/2 percentage point of annual growth this year and next year, but there is some upside risk that the effects could be larger.”

Policymakers need to be aware of tax reform’s implications for “the longer-run budget deficit,” she warned. Even prior to the tax plan’s passage, longer-run deficits were “unlikely to be sustainable,” she said. Should growth not pick up as expected, it would increase the chance “the government would eventually need to respond with some combination of increased borrowing, reduced or restructured benefits, and increased taxes, thereby reducing any long-run positive effects of the recent changes in fiscal policy.”

Mester wrote off recent stock market volatility, noting, “trading has been relatively orderly, markets have remained generally liquid, and there hasn’t been a pullback in credit.” It would take “a deeper and more persistent drop in equity markets” to “dash confidence and lead to a pullback in risk-taking and spending,” which is far from what has occurred. “I expect the economy will work through this episode of market turbulence and I have not changed my outlook. In my view, the underlying fundamentals supporting the economy are very sound.”

Mester is a voter on the Federal Open Market Committee in 2018.

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