MNI: Fed's Mester Sees Rate Cuts Likely Later This Year

The Federal Reserve will likely be comfortable lowering interest rates at a gradual rate later this year while allowing the balance sheet to continue to shrink, Cleveland Fed President Loretta Mester said Tuesday, echoing Fed Chair Jerome Powell's message after last week's FOMC meeting.

"The current strength in labor market conditions and the strong spending data give us the opportunity to keep the nominal funds rate at its current level while we gather more evidence that inflation truly is on a sustainable and timely path back to 2%," she said in remarks prepared for an Ohio Bankers League summit in Columbus, Ohio.

"If the economy evolves as expected, I think we will gain that confidence later this year, and then we can begin moving rates down. My base case is that we will do so at a gradual pace so that we can continue to manage the risks to both sides of our mandate."

RISKS TO THE OUTLOOK

If downside risks materialize, the Fed could move rates down more quickly. But if inflation appears to be stalling at an above-goal level, the FOMC could maintain a restrictive stance for longer, Mester said. Her baseline forecast is for output and employment to moderate this year and inflation to move closer to 2% over time.

"Heightened geopolitical tensions have potential implications for financial markets, oil prices, and global demand and supply. A continued easing in financial conditions could spur activity, leading once again to imbalances that fuel inflation," she said.

Banks could also experience further stress from relying on uninsured deposits for funding while having sizable exposures to commercial real estate assets that need to be repriced at higher interest rates, she said.

"So while labor markets are currently strong and are expected to only gradually moderate, we need to remain attentive to the possibility that conditions could deteriorate faster than expected. On the other hand, the strong output and employment growth could be an indication that the neutral rate of interest, which rose during the pandemic, might remain high, which would mean restrictive policy may be needed for longer to achieve our goals of price stability and maximum employment," she said.

Tapering QT

Rate adjustments are the main tool of monetary policy, but the Fed can continue to allow assets to mature from its balance sheet "even after we begin to lower the funds rate," Mester said.

So far, QT has resulted in a reduction in usage of the overnight reverse repo facility rather than a reduction in reserves, she noted. Reserve balances are about USD3.5 trillion or 15% of banking system assets. A September survey of senior financial officers indicated that most banks have more reserves than they prefer and there are little funding pressures.

"What constitutes an ample level of reserves is uncertain," she said. "The current level and distribution of reserves are more than ample. But as balance-sheet runoff continues and ON RRP volume reaches a minimum level, reserves will begin declining, too, and more redistribution of reserves will need to occur across institutions." (See: MNI INTERVIEW2: Fed Assets To Settle Near USD7T Post QT-Kaplan)