Fed’s Loretta Mester raises long-term rate outlook on strong US economy

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A top US monetary policymaker has said the strength of the US economy means that interest rates are unlikely to fall as far as expected in the longer term, as she all but ruled out a cut as soon as May.

Loretta Mester, president of the Cleveland Federal Reserve and a voting member of the Federal Open Market Committee, revealed in a speech on Tuesday that she had raised her estimate of the longer-run federal funds rate from 2.5 per cent to 3 per cent.

Mester also said she needed to see more evidence of inflation falling towards the central bank’s 2 per cent goal before moving to lower borrowing costs from their current 23-year high of 5.25-5.5 per cent.

“It’s hard for me to get there by May,” she said during a press briefing, referring to the policy vote scheduled for May 1. A cut at the Fed’s mid-June vote would be a possibility, she added. “I wouldn’t rule that out. We just need to see more evidence that inflation is on that sustainable downwards path towards 2 per cent.”

While investors’ expectations for the timing of a first cut have already drifted out towards June, Mester is the first member occupying the committee’s centre ground to rule out a move until June so explicitly.

Inflation surged to a multi-decade high in 2022, sparking 525 basis points’ worth of rises from the central bank.

A sharp slowdown in price pressures during the second half of 2023 led rate-setters to shift away from rate rises and towards considering cuts. However, recent price data has been disappointing, showing inflation edging up. The US economy, meanwhile, remains resilient, enabling policymakers to take a patient approach towards cutting rates.

Nine FOMC members still expect three quarter-point rate cuts this year, leaving the Fed’s benchmark rate at 4.5-4.75 per cent by the end of the year. “I think three is still reasonable, but it’s a close call,” Mester said during the briefing.

Separately, Mary Daly, president of the San Francisco Fed and another voting member of the FOMC, told an event in Las Vegas that three cuts remained “a very reasonable baseline”. She added, however: “A projection is not a promise.”

Markets are also expecting three cuts.

Mester said the change in her longer-term rate forecasts reflected “the continued resilience in the economy despite high nominal interest rates and higher model-based estimates of the equilibrium interest rate”.

The equilibrium interest rate, or R-star, is the rate at which the Fed can consider borrowing costs to be neutral, neither inflating nor deflating demand in the economy.

Mester said during the briefing that higher productivity growth and greater investment, notably in technologies relating to climate change, had led her to shift her view after spending “a long time” at 2.5 per cent.

The FOMC’s projections show members’ estimates for interest rates at the end of 2024, 2025, 2026 and for an unspecified longer term. The median longer-term estimate rose slightly, from 2.5 per cent to 2.6 per cent, in its most recent projections, unveiled last month.

While Mester will leave the FOMC in June, economists expect more debate between the committee’s members on longer-term interest rates later this year.

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