Central bankers should acknowledge blind spots in a less certain world,
Fed's Mester says
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[May 24, 2024] By
Howard Schneider
AMELIA ISLAND, Florida (Reuters) - In nearly 40 years working for and
helping lead the Federal Reserve, Cleveland Fed President Loretta Mester
was part of a revolution that saw the U.S. central bank offer ever more
detailed and plentiful commentary on the economy and monetary policy.
As she heads towards mandatory retirement in June, the Cleveland Fed
chief has a parting thought: With the economy in flux following the
COVID-19 pandemic and with uncertainty surrounding even basic aspects of
how things work, precision may be an enemy.
"Markets certainly want to know exactly ... 'when are you going to cut
rates?' That's what they focus on," Mester, 65, said in an interview
with Reuters on the sidelines of an Atlanta Fed conference this week.
"The public ... doesn't want to hear a whole bunch of complicated stuff.
They want to kind of know 'what do you really think?'"
"We've become much more transparent over time," she said, but "we're not
prescient. We don't know exactly how things are going to be ... If the
economy evolves differently than you're expecting, and materially
differently, ... your policy should respond to that."
Given how much is unknown, she said the Fed should build more of that
uncertainty into how it talks about policy, focusing less on a baseline
or "modal" outlook and more on a handful of the most likely outcomes -
or scenarios - that would help the public better focus on how
policymakers would react when the economy, as will inevitably happen,
does something different than expected.
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"If you only communicate the modal view, you're kind of miscommunicating
your actual view about the economy to the public," Mester said,
referring to economic projections made early in the pandemic as an
extreme example of how any outlook relies on sets of assumptions that
she feels are becoming harder to make.
'ACTIVE DISCUSSION'
Mester is retiring before a Fed review, expected to start later this
year, of how the central bank sets policy, the tools it uses to
implement its decisions, and the strategy for communicating it - an area
she argues needs particular work.
The Atlanta Fed conference in Amelia Island, Florida, this week was
focused on some of the questions the central bank wants to answer about
the post-pandemic economy, showing a shared sense among policymakers
that the upcoming era, coupled with changing trade relations and
volatile geopolitics, could prove challenging for central banks to
navigate.
David Zervos, chief market strategist for Jefferies, argued, for
example, that the Fed's use of bond-buying during the crisis might be
one thing that blunted the eventual impact of monetary policy when rates
started to rise because it imported onto the Fed's balance sheet losses
that would otherwise have been borne by the public and driven down
spending.
Others delved into ways the U.S. housing market may be muting the
central bank's impact rather than amplifying it, as had been the case in
the past, and warned how the broad economic backstops the Fed rolled out
during the pandemic might reset the baseline for what it would be called
on to do during the next shock.
"It's an active discussion ... as to how we should think about the
longer term," Atlanta Fed President Raphael Bostic said in an interview
with journalists on the sidelines of the Amelia Island conference. "We
know there have been changes that have come about because of the
pandemic, in how labor markets work, in terms of supply chain
diversification, and all those things that could change the baseline
level of energy in the economy."
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![](../images/052424PIX/busine84.jpg)
Loretta J. Mester, president and CEO of the Federal Reserve Bank of
Cleveland, speaks at a conference at the Columbia University in New
York, U.S., February 29, 2024. REUTERS/Lananh Nguyen/File Photo
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How that plays out over the long term is one thing for analysts to
try to understand.
But monetary policy is responsible for stabilizing prices and
employment in the short to medium term, an exercise that
traditionally focuses on managing demand since that is the aspect of
the economy most immediately influenced by interest rates - the cost
of borrowing money.
However, it also depends on how the economy is expected to evolve
over time, and that calculation becomes complicated if things like
productivity, the neutral rate of interest, or the likelihood and
impact of supply shocks aren't either relatively stable or at least
changing in familiar and somewhat predictable ways.
BOOSTING CREDIBILITY
The pandemic, Mester noted, essentially put central bankers in the
role of epidemiologists and virologists - far from their expertise -
since any plausible outlook for the economy depended on assumptions
about infections, viral variants, and vaccines.
Similarly, she said, if policymakers can no longer assume that
supply shocks quickly fade, for example, or they find the economy
responding differently than before to a given level of interest
rates, economic modeling and projection lose their footing.
"That increases the level of uncertainty so you have to become much
more nimble. How do you set yourself up so that you're well
positioned no matter how things go?" Mester said, noting how the
initial assumption that rising inflation in 2021 would prove
"transitory" delayed interest rate hikes that she feels could have
started earlier and proceeded with less risk and drama.
Better communication about how much the Fed doesn't know, she said,
could help avoid that sort of mistake in the future by discussing,
be it in each policy statement or in less frequent documents like
the biannual monetary policy report to Congress, the most likely
economic narratives and the "reaction function" Fed officials would
use in response to them.
Getting the Fed's disparate group of up to seven governors and 12
reserve bank presidents on the same page about that approach may be
a challenge, Mester acknowledged. But in her view it would boost the
central bank's credibility to be blunt about the spread of possible
outcomes rather than allow more precise public expectations to
develop and then be proven wrong.
"Let's just pick three salient scenarios. There's going to be one
that probably has a little more weight on it ... This is what we
think is going to happen. However, we have these alternative risks.
"That isn't a trivial thing to do," she said, but "that can only
enhance your credibility."
(Reporting by Howard Schneider; Editing by Paul Simao)
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