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By HaleStewart May 20, 2018 12:10 pm
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US Bond Market Week in Review: A Look at Loretta Mester's Hawkish Reasoning

               Loretta Mester is the president of the Cleveland Federal Reserve.  While her speeches are normally more general in nature, her May y14 presentation to the Global Interdependence Center contains more detail, allowing us to better understand her more hawkish analysis of the U.S. economy and Fed policy.

            Let’s begin with her general opinion about the macro economy:

Over this year and next, I expect above-trend output growth, continued strength in labor markets, and firming inflation. I believe the U.S. economy is slightly beyond maximum employment, from the standpoint of the cyclical conditions monetary policy can address, and that inflation will reach our symmetric 2 percent goal on a sustainable basis over the next one to two years. This outlook is based on favorable underlying fundamentals, including accommodative monetary and fiscal policies, healthy household balance sheets, rising personal income, a global economy that is improving overall, and stable inflation expectations.

 “Above-trend growth” describes the relationship between projected GDP growth (which is a combination of population and productivity advances, along with increases in investment spending) and actual growth.  When real growth is faster than projected growth, inflation results.  “Maximum employment’ also has inflationary implications.  Basic economic theory holds that maximum employment causes inflation.      

Mester also bases her future bullish projections on three recent developments.  The Tax Cuts and Jobs Act and increased federal spending will increase domestic demand while the synchronous nature of global growth should increase foreign appetite for U.S. goods (although the dollar’s strength could limit growth).  These are all sound economic prognostications. 

Let’s turn to the Mester’s opinion regarding the labor market.  Mester believes the economy is near full employment which is largely supported by the data.  The unemployment rate is 3.9%.  The moving averages of establishment jobs growth are also very strong:

The monthly jobs data is noisy any subject to numerous revisions.  Using various moving averages removes that noise.  The 3, 6, and 12-month moving average of jobs gains are clustered around 200,000 – a very strong pace for an economy this far into an expansion.  Other jobs market data also supports Mester’s “full-employment” description:

The above chart is from the Atlanta Fed; with the exception of wages, labor market indicators are currently above their respective highs of the last expansion.

As for prices Mester argues, “I expect to see month-to-month variation in the numbers around an underlying upward trend in inflation, as inflation moves to our goal on a sustainable basis over the next year or so.”  Here, she runs in the same problem that the Fed has had for the last five years: prices have been reluctant to comply with the Fed’s near-constant projection for prices to move above 2%.  A look at the moving averages of PCE price increases shows the problem:

As with the jobs numbers, the moving averages remove the monthly noise from the indicator.  Currently, all the moving averages are below the 2% level.  And we’ve been in this exact situation before (where the 3 and 6-month averages are rising) almost exactly one year ago.  While Mester comments that the Fed’s 2% PCE target is symmetrical (meaning the Fed would be concerned if prices spent a prolonged period below or above 2%) she seems ready to pull the trigger on rate hikes before prices are above the 2% for any length of time.   

Mester bolsters her argument by noting that anecdotal evidence from businesses in her district indicate increasing pricing pressure.  This is supported by the latest Beige Book, which observed:

Prices increased across all Districts, generally at a moderate pace. There were widespread reports that steel prices rose, sometimes dramatically, due to the new tariff. Prices for building materials continued to rise briskly, especially for lumber, drywall, and concrete. Transportation costs also generally rose, with contacts citing higher fuel prices and shortages of truck drivers as the primary causes. There were scattered reports of companies successfully passing through price increases to customers in manufacturing, information technology, transportation, and construction. Businesses generally anticipate further price increases in the months ahead, particularly for steel and building materials. 

The latest ISM manufacturing report adds further confirmation.  Nevertheless, the latest Fed projections don’t have the PCE price index rising to 2% until 2019.  Although Mester’s price arguments are on sounder footing than they would have been a year ago, there is still sufficient uncertainly surrounding the PCE index to warrant caution when projecting sharp price increases.

              Mester is undoubtedly one of the more hawkish members of the Fed.  Her analysis of the macro economy and labor market are strongly supported by the data.  Her view on prices, however, are less so.  The PCE index’s move above 2% is recent; and the Fed has been projecting that prices would move above 2% “in the intermediate term” for several years, only to have prices remain weak.  The Fed should wait for the PCE price index to remain above 2% for more than a month before taking a more hawkish polity stance.  


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