Gradual rate hikes are likely to remain necessary, and the normalization of the Federal Reserve’s balance sheet should not cause a “sudden or sizable increase in long-term yields,” Federal Reserve Bank of Cleveland President Loretta Mester said Thursday.

“In my view, if economic conditions evolve as anticipated, I believe further removal of accommodation via gradual increases in the fed funds rate will be needed and will help sustain the expansion,” Mester told the Economic Club of Pittsburgh, according to prepared text released by the Fed.

Federal Reserve Bank of Cleveland President and CEO Loretta J. Mester.
Federal Reserve Bank of Cleveland President and CEO Loretta J. Mester. Bloomberg News

Since monetary policy works with a lag, she said, “we can’t wait until these policy goals are fully met to act. We need to assess what incoming information is telling us about where the economy is going over the medium run, and the risks around that medium-run outlook, and set policy appropriately.”

On balance sheet normalization, Mester said, “I favor doing this in the near future.” Since the plan has been publicized and will be a gradual reduction, she noted it shouldn’t cause a spike in long-term yields. “Indeed, in my view, other factors, including the ongoing discussions about the debt ceiling, rising geopolitical tensions, and political uncertainty, would be more likely to influence Treasury yields in the near term.”

The Fed’s moves to normalize monetary policy, she said, is “a welcome acknowledgment that the economy itself has normalized.”

Inflation will be below the Fed’s 2% target “for somewhat longer” before it will “gradually return over the next year or so to our symmetric goal of 2 percent on a sustained basis.”

Turning to the labor market, Mester said, in terms of what monetary policy can influence, “we have achieved the maximum employment part of the Fed’s monetary policy mandate. At the same time, there are some longer-run structural issues in the labor market that cannot be addressed by monetary policy but that the country must tackle.”

Weak wage growth, “suggests to some that there is still considerable slack in labor markets and that the longer-run unemployment rate is lower than the current rate,” Mester noted. But, she added, “For me, a more salient factor in the relatively slow growth in wages is the low level of productivity growth.

Without productivity gains, she said, “I wouldn’t expect to see a strong acceleration in wages.”

The economy will expand at a pace faster than trend — which she defined as 2% — in the next "year or so."

“The hurricane in the Gulf will likely dampen economic activity in the current quarter, with subsequent rebuilding efforts adding to growth in subsequent quarters.”

While storms are not typical, variation by quarter “not unusual.”

“We are gathering information from our contacts, but it is still too early to assess the full economic impact of the storm,” she said.

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Gary Siegel

Gary Siegel

Gary Siegel has been at The Bond Buyer since 1989, currently covering economic indicators and the Federal Reserve system.