MNI INTERVIEW: Fed's Mester Focused on QT Impact on Liquidity

Federal Reserve Bank of Cleveland President Loretta Mester told MNI Wednesday she's more concerned about the potential for quantitative tightening to constrain market liquidity than its effect on financial conditions, and she favors letting the USD95 billion-a-month asset run-off program continue on autopilot.

"I'm more focused on whether it's going to have an impact on liquidity in the markets than I am on how much the equivalent is on a fed funds rate," she said in an MNI webcast. "We're monitoring to make sure it's not disrupting anything. So far, so good."

Some investors and a former regulator have warned recently that QT could have a much larger tightening effect than the Fed expects, especially if growth slows dramatically. Fed researchers also anticipate a potential amplification of its effects should the Treasury market experience high turbulence. (See: MNI INTERVIEW: Market Strains Could Ramp Up QT Effect)

Ahead of the FOMC's announcing its QT plan in May, policymakers discussed an approach that would set a pace for reducing the Fed's USD9 trillion balance sheet with a high bar for further adjustments once it was set running. "I'm persuaded by that," Mester said. "We have less experience with balance sheet reduction," she added. "There's a lot of interesting research out there about whether QT is symmetric with QE, and there's various reasons to think that it may not be."

MBS SALES

Even as she favors leaving the speed of QT untouched, Mester argued for more active management of the composition of the Fed's asset portfolio.

As Treasury assets mature faster than MBS, "we should be contemplating selling the MBS part of our portfolio," she said. "At some point it probably makes sense to think about doing that so that we get the composition back to primarily Treasuries, which was one of our principles that we put out."

Most FOMC officials are in agreement on making such a move when rate hikes are "well underway," according to the minutes of Fed meetings earlier in the year.

Mester, a voter on rates this year, reiterated in her prepared remarks her view that the fed funds rate should rise above 4% by early next year and stay there. The dollar has continued to rise as investors anticipate further rate hikes. Fed funds futures traders are pricing in 67 bps of tightening later this month, close to last week's levels before Friday's jobs report for August, and rates are expected to peak at 3.91%. They are currently in a target range of 2.25% to 2.5%.