Persistent Inflation Demands a Slow Approach to Rate Cuts, Cleveland Fed’s Mester Says

The Fed has made substantial progress on bringing the rate of inflation down since its peak in 2022, but it remains above the central bank’s 2% target. The readings for January and February came in stronger than expected, interrupting a trend of slower price growth that had been in place for most of 2023.

“It’s a good reminder of what we already knew: the disinflation process won’t be a smooth path back to 2%,” Mester said on Tuesday afternoon, speaking at the Cleveland Association for Business Economics & Team NEO luncheon.

Mester is a voting member of the Federal Open Market Committee, the Fed’s policymaking body, this year. She has led the Cleveland Fed since 2014.

The Fed’s preferred measure of inflation, the core personal consumption expenditures price index, was up 2.8% from a year earlier in February, and 2.9% higher in January. It has averaged a 3.1% annual increase over the past six months, after peaking at 5.6% in 2022.

“I think the most likely scenario is that inflation will trend back to 2% over time, but I need to see more data to gain greater confidence,” Mester said. “I don’t expect I will have enough information by the time of the FOMC’s next meeting [in May] to make that determination.”

Traders aren’t expecting a cut in May either. Prices for interest-rate futures imply nearly 60% odds of a quarter-point decrease at the committee’s June meeting, and the greatest likelihood of a total 0.75 percentage-point reduction in 2024. The FOMC has held its target range for the federal-funds rate steady at 5.25% to 5.5% since July 2023.

Mester said she now expects better 2024 economic growth than previously, based on the strong start to the year, forward-looking data, and anecdotes from businesses and individuals in her district. Growth will moderate, but gross domestic product will still increase at an above-average pace in 2024, she said. The unemployment rate might tick up slightly but the labor market should stay strong, Mester said.

If the economy and inflation evolve as expected, it will be appropriate for the Fed to begin to lower interest rates later this year, Mester said. The goal won’t be economic stimulus, but to move monetary policy back to normal territory. Keeping rates steady as inflation declines means an increase in the real, or inflation-adjusted, rate of interest.

“These reductions should be viewed as a normalization of policy back to a neutral level as the economy returns to price stability and maximum employment,” she said, citing the Fed’s dual mandate.

After this year, interest rates might not need to come back down as far as they did in the decade between the 2008-2009 financial crisis and the Covid-19 pandemic. Mester said that she changed her forecast of the long-run fed-funds rate to 3% last month, from 2.5%.

“I raised my estimate to reflect the continued strength and resiliency in the economy despite high nominal interest rates and higher model-based estimates of the equilibrium interest rate,” Mester said.

The so-called neutral rate of interest is the level that neither stimulates nor restricts economic activity. An increasing cohort of economists and Fed officials are warming to the view that the neutral rate is higher in the postpandemic economy than previously thought.

Write to Nicholas Jasinski at nicholas.jasinski@barrons.com