**MNI EXCLUSIVE: Fed's Mester Sees Stronger Inflation Ahead

--Won't Overreact to Temporary Overshoot of 2% Goal

--Fiscal Stimulus to Rev Growth over Next Yr; Supply-Side Boost Modest

--Fed Forward Guidance Due for Update

By Jean Yung 

     CLEVELAND (MNI) - Stronger and more volatile U.S. inflation readings could

pose a challenge for Federal Reserve policymakers in how best to communicate

that a temporary overshoot does not shift their medium-term outlook and that

policy remains appropriately calibrated to achieve their dual mandate, Cleveland

Fed President Loretta Mester said in an exclusive interview with MNI Tuesday.

     She and other officials have said the Fed must slowly pare back monetary

stimulus as inflation picks up speed amid above-trend growth and a tight labor

market. Higher commodity prices as well as lower readings from last year

dropping out of the calculation suggest inflation could rebound relatively

quickly this year, prompting the Fed's policymaking committee to raise rates

again at its next meeting in June.

     "In the near term we could see some stronger numbers," said Mester, a voter

this year on the Federal Open Market Committee. "Inflation is on a gradual

upward path. We need to continue our gradual upward path on interest rates." 

     Yet policymakers will need to parse inflation data carefully in the coming

months to understand whether price pressures are gaining ground relative to

their expectations. The FOMC earlier this month underscored in its policy

statement its "symmetric" inflation target to emphasize that the committee

"would be concerned if inflation was running persistently above or below our

goal," Mester said.

     "We need to be explaining to markets that one month's reading above 2% is

not something to cause panic," she said. "I think we're getting closer on the

inflation front, and I think we're a little bit beyond on the labor front. I

think we're close." 

     --3% TERMINAL RATE

     Mester sees the economy growing at a 2.5% to 2.75% clip this year, boosted

by tax cuts and government spending among other factors, before settling back

down to a more sustainable pace of 2%.  

     That fiscal stimulus could shift the economy into higher gear Mester

believes is "possible," but such effects would only be felt after a couple years

and don't currently figure into her outlook. 

     "Typically, you don't see that much of an impact" on the supply side of the

economy, she said. "It's possible it could have a bigger impact than I'm

anticipating, but I didn't put much into my own forecast for that." 

     Over the long run, demographics and productivity drive growth rates as well

as interest rates, she said, and in her view, current trends cap the terminal

fed funds rate at around 3%, a relatively low ceiling compared to recent

decades. 

     Her estimate is not far out of the mainstream on the FOMC, suggesting the

Fed has only a few more rate hikes ahead of it before monetary policy reaches a

neutral level. 

     --FED'S REACTION FUNCTION

     As monetary policy normalizes, it becomes more important for the Fed to

hone its communication strategy, Mester said. 

     Whereas the FOMC's longstanding pledge to keep policy accommodative helped

calm markets when rates were near zero, such explicitly asymmetric forward

guidance needs to be replaced with more balanced explanations of how the Fed

will calibrate policy given a broad range of economic indicators. 

     "We want to convey that we're systematic in how we approach policy," Mester

said. "It's particularly important now in this post-Great Recession world

because we did take extraordinary actions during the financial crisis -- needed

actions. I think it's harder now for people to know what our reaction function

is, because the near history is these extraordinary actions."

     That could involve changes to the FOMC policy statement to convey "if

conditions evolve in this way, this is how we set policy; if they evolve in this

way, this is how we set policy," Mester said. 

     The dot plot, which charts the forecasts for future rate increases from

every FOMC member, is another useful communications tool, she said.

     "It's a good way of giving a visual and a narrative about where we think

policy may be going given the forecast," she said. The addition last year of

wide confidence bands around the median path "is another important thing for

people to understand -- that policy will react appropriately to shocks to the

economy if need be."

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

[TOPICS: MMUFE$,M$U$$$,MT$$$$,MX$$$$]