Top Fed official lays out the case against a July interest rate cut

Loretta Mester said her baseline forecast calls for slower, but still solid, growth of around 2 per cent in 2019.
Loretta Mester said her baseline forecast calls for slower, but still solid, growth of around 2 per cent in 2019.PHOTO: REUTERS

WASHINGTON (BLOOMBERG) - Loretta Mester has laid out the argument against a rate cut this month, while many of her colleagues in the US central bank are leaning hard toward it and investors assume it's on the way.

The president of the Cleveland Fed, speaking on Tuesday (July 2) in London, said her baseline forecast calls for slower, but still solid, growth of around 2 per cent in 2019 - even as she acknowledged that downside risks are on the rise.

"Cutting rates at this juncture could reinforce negative sentiment about a deterioration in the outlook even if this is not the baseline view," she said. A cut "could also encourage financial imbalances given the current level of interest rates, which would be counterproductive."

Mester and any allies on the Federal Open Market Committee will have a tough job swaying their colleagues against a cut when they gather in Washington July 30-31.

Last month, when the committee signaled an openness to reduce rates, eight out of 17 policy makers indicated in forecasts that they expect to cut this year. Fed Chairman Jerome Powell may have revealed in his post-meeting press conference that he was among those favouring cuts.

Investors have taken the hint, with prices of federal funds futures contracts implying a 100 per cent probability of a cut on July 31, including about a 20 per cent chance of a half-percentage-point move as of Tuesday.

Responding to questions from the audience following her speech, Mester mostly brushed aside market expectations.

"We want to infer something from that, but some of it's noise and some of it's signal," she said. "If you always react to the market, it's self-reinforcing and you'll never get a signal."

Mester, a PhD economist who has leaned toward the hawkish end of the FOMC since she took office in 2014, said the need for cuts hinges on the question of whether the economy is simply slowing toward a sustainable level of growth or headed for a more significant deceleration.

WEAK GROWTH

"There is some chance that an alternative, weak-growth scenario could be emerging," she said. To justify a cut, Mester added that she would would want to see "a few weak job reports, further declines in manufacturing activity, indicators pointing to weaker business investment and consumption, and declines in readings of longer-term inflation expectations."

 
 

But that is not what she expects.

"The most likely outcome continues to be that the economy will maintain its good performance in 2019," she said.

Mester compared recent months to a soft patch the US economy weathered in 2016, when the Fed backed off from a forecast of four rate hikes for that year after lifting rates in December 2015. The Fed ultimately waited out that stretch and resumed increases in December 2016.

LOW INFLATION

"So long as the sustainable-growth scenario of continued expansion and strong labour markets remains the baseline outlook, I would favour taking a similar opportunistic approach," she said.

She also pushed back against the idea, advanced recently by Minneapolis Fed President Neel Kashkari, that low inflation alone could justify a cut.

 
 

"If it is the case that non-monetary structural factors are holding back measured inflation, thereby putting downward pressure on inflation expectations, rather than an aggregate demand problem, it is not clear how effective this policy would be," she said.

The Fed's favored gauge of inflation remained well below target, at 1.5 per cent, in the 12 months through May. More worrying, measures of expectations for the future level of inflation have slipped recently, both in market- and survey-based metrics.

PRICE PRESSURES

Mester said declines in energy prices and structural factors weakening price pressures have caused her to revise down her near-term forecast for inflation, but she continued to expect it would return toward 2 per cent "over the next couple of years."

Based on recent public comments, and assuming no significantly negative data emerges this month, Mester is likely to get support at the July 30-31 meeting from Dallas Fed President Robert Kaplan. He said June 24 he was worried a rate cut "would contribute to a build-up of excesses and imbalances in the economy."

Richmond Fed chief Thomas Barkin, another potential ally, was non-committal on June 25 when asked about the need for a cut.