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By HaleStewart August 28, 2016 8:08 am
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US Bond Market Week in Review: Yellen Can Expect Support From Cleveland President Mester

     This week, Fed President Yellen stated we could expect at least one rate hike soon.  Yellen can expect support for that policy prescription from Cleveland Fed President Loretta Mester who is one of the more hawkish Fed members.   Mester made her opinions clear in a speech on July 13, given in Australia where Mester made the following observations about the economy:

In my view, the underlying fundamentals supporting the U.S. economic expansion remain sound. These include accommodative monetary policy, household balance sheets that have improved greatly since the recession, continued progress in the labor market, a more resilient banking system, and low oil prices.

While she observes the more commonly accepted importance of low interest rates (“an accommodative monetary policy”) and low unemployment (“continued progress in the labor market”), she also focuses on three lesser cited statistics supporting expansion.  The financial obligations ratio is near its lowest level since the early 1980s, indicating families deleveraged after the Great Recession.  The new Graham-Dodd regulations requiring additional capital have strengthened bank balance sheets.  And Mester obviously agrees with James Hamilton about the importance of oil prices to the economy.

Consumer spending, which makes up about two-thirds of output in the U.S., has accelerated in recent months. The continued improvement in household balance sheets, growth in personal income, low borrowing rates, and relatively low oil prices have all buoyed consumer spending.

Retail sales and personal consumption expenditures are growing at solid rates, indicating the consumer, who is responsible for over 70% of economic growth, is spending at a pace to support economic growth.  She also notes the importance of consumer credit to consumer spending.  Mester places a great deal of understandable emphasis on U.S. consumer’s health, which is in very good shape.

     After noting that parts of the housing market have clearly rebounded, she notes:

Other parts of the housing sector haven’t yet fully recovered. Construction and sales of new homes have been rising at a gradual pace, but they are not back up to their pre-bubble levels. Starts remain below the levels consistent with projections of household formation over the longer run, and in some markets, the supply of housing hasn’t kept up with demand. In addition, the type of housing being built has shifted. Over the past five years, increases in multifamily housing starts have significantly outpaced increases in single-family starts. This may reflect a shift in preferences toward more urban living, but it likely also reflects the desire on the part of some people who lived through the crisis to rent rather than own.

The following chart illustrates her points:

Housing permits (in blue) and starts (in red) are still at historically low levels, supporting her bullish outlook: the current construction pace is below the rate of family formations, indicating pent-up housing demand exists.  This will support growth for the foreseeable future.

     On the bearish side, Mester observes that business investment is weak – and the weakness in not solely attributable to weak oil prices, although that sector’s slide obviously started the investment malaise.  While she expects investment to eventually rise, she ties this factor into low productivity, noting:

Structural productivity growth is a key determinant of the longer-run growth of output and increases in living standards. And investment in capital, including human capital, is a key determinant of productivity growth. In the U.S., labor productivity growth has risen at only a half of a percent annual rate over the past five years. Part of this weakness is cyclical: weak investment during the recession and early part of the expansion contributed to slow productivity growth over this five-year period. But the weakness in investment and the slow productivity growth have persisted in the U.S. and in several other countries.    

Weak productivity growth, which is a primary reason for weak top-line GDP growth, is now attracting attention from economists who have offered a variety of explanations.  Mester implies that productivity growth should accelerate to some degree once capital investment resumes.

      Turning to the Fed’s dual mandate, Mester argues that the 4.9% unemployment rate, low level of initial claims and improving utilization measures show a solid labor market.  Prices, which were uncomfortably low a few years ago, have started to move higher.  The Cleveland Fed’s median CPI measure is 2.5%, 50 basis points above the Fed’s 2% target.  Overall, Mester believes the economy is close the achieving the Fed’s dual mandate, clearly implying she believes a rate hike is appropriate.

      But while the timing of that event is fluid, she is just as concerned about the impact of not raising rates:

But there are also risks to forestalling rate increases for too long when we are continuing to make cumulative progress on our policy goals. Waiting too long increases risks to financial stability and raises the chance that we would have to move more aggressively in the future, which poses its own set of risks to the outlook. I believe waiting too long also jeopardizes our future ability to use the nontraditional monetary policy tools that the Fed developed to deal with the effects of the global financial crisis and deep recession. If we fail to gracefully navigate back toward a more normal policy stance at the appropriate time, then I believe there is a non-negligible chance that these tools will essentially be off the table because the public will have deemed them as ultimately ineffective.

The longer the Fed utilizes “extraordinary measures” the more the impact of these policies becomes ingrained in the national economic psyche, making it harder to remove.  This is why Mester will be a solid vote for Yellen. 



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