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Repeats Story Initially Transmitted at 20:00 GMT May 22/16:00 EST May 22
--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 and Sara Haire
     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
--MNI Washington Bureau; +1 212-800-8517; email: sara.haire@marketnews.com
[TOPICS: MMUFE$,M$U$$$]