Fed's Mester sees US economy warranting gradual rate increases

[WASHINGTON] Bad things happen when the US central bank holds interest rates too low for too long, Loretta Mester said in an interview, as she urged her colleagues to deliver on gradual policy tightening.

"I don't think we're way behind the curve," the Federal Reserve Bank of Cleveland chief told Bloomberg News after a speech Monday in Chicago.

"In this environment, where we continue to make progress toward our goals, we need to move interest rates up, because if you don't, you will be behind, and then the outcome of that is never good."

Policy makers will next meet in June to decide whether to pull the trigger on their third rate increase in six months. They kept rates on hold last week, making clear they were not discouraged by weak growth in the first quarter, which they described as "transitory", while the labour market had strengthened and inflation was seen rising to their 2 per cent target.

Proponents of a June hike will likely point to robust employment data that has dropped the US jobless rate to 4.4 per cent, its lowest since 2007. At the same time, policy makers inclined to wait can cite feeble wage gains, which slowed a touch to a 2.5 per cent in the 12 months through April. The combination of such low unemployment and relatively tepid wage growth has continued to puzzle economists.

Very Low

While she didn't explicitly advocate for a June rate increase, Ms Mester said wages didn't provide a strong enough reason to stray from a gradual pace of raising borrowing costs.

"Wages are not determined necessarily by the labor market alone," she said. "It's basically in combination with productivity growth," which remains very low.

"We have seen some acceleration in wages, it just hasn't gotten back to where we were before," she said.

"This thought that we have to see 3 per cent or 3.5 per cent, in this environment, no."

Still, Ms Mester said she's open to re-evaluating her estimate for the level at which unemployment begins to trigger inflation, which she currently puts at 5 per cent.

"Maybe I'm wrong and maybe that's lower than 5 per cent. But in the past when central bankers have lowered those estimates, that's when you've gotten into a little bit of an issue," she said.

Ms Mester repeated that she would like to see the Fed begin to shrink its US$4.5 trillion balance sheet this year, adding that she doesn't think it's having a major impact on market interest rates.

The Fed expanded the balance sheet five-fold via purchases of Treasuries and mortgage-backed securities, as it sought to lift growth by holding down long-term borrowing costs after the 2008 financial crisis. It currently maintains the size of the balance sheet by reinvesting the principle of bonds as they mature.

"We could probably end re-investments and not see a big impact, as long as we articulate it well," she said.

BLOOMBERG