Mester Stresses Need for Fed to Prioritize Inflation Containment Amidst Current Forces
Former Clevenland Fed President urges Fed to learn lessons from policy mistakes made duing past episode of shocks like Pandemic
Loretta Mester’s four decade career at the Federal Reserve started at the Federal Reserve Bank of Philaphelphia where she rose to be the Director of Research, as such attending the policy meetings in Washington alongside her “boss,” former Philly Fed president Charles Plosser.
And continued when she served as president of the Cleveland Fed from 2014 to 2024, a critical period that included the economic and finanancial aftermath of the Great Financial Crisis and importantly the Pandemic years when inflation got out of control and the Fed had to bring it back down with aggressive rate hikes.
So now, as the war in the Middle East has hit financial markets, driving oil prices to extreme levels, what does Loretta expect the Federal Reserve to do at its coming policy meeting: cut, hike, or hold rates steady?
For starters Loretta says inflation looked pretty tame in the lastest consumer price index report: the headline CPI rose 0.3% in Januaryr and the core CPI takes out food and energy rose 0.2%. Loretta emphasized the backward-looking nature of the Consumer Price Index (CPI) report. “Certainly the report that came out today gave them a good picture of where things were before the oil price shock,” she says, but the big challenge now is seeing what comes next as the is deciphering challenges posed by the recent Middle East conflict and its impact on oil prices, supply disruptions, and inflation.
“An oil price shock...has some dampening effect on growth and raises total headline inflation for a time, but doesn’t really pass through much to core inflation,” she says. “They’re not going to really know how long the oil prices will stay at elevated levels, so they’ll use the models to sort of work through that.”
As for the coming Fed policy meeting, Loretta recommends officials take a cautious approach. “They’d be wise to leave things where they are...until they get more evidence on how things are going to evolve in both employment and inflation.”
Loretta was quick to point out that the Fed made a big mistake during the pandemic by letting inflation go too high for too long and officials now need keep this in mind.“We should have been moving rates up sooner than we were because aggregate demand was outpacing supply.”
And she immediately zeroed in on the persistence of inflation staying above the Fed’s target for nearly five years. “Certainly the inflation rate has come down from the peaks that we saw in the post-pandemic period, but it’s still running above 2%.”
”But we’re above the level and we’ve been above for a long time, which is why I would be focusing in on the inflation side right now, unless we get more evidence that there’s a much more, you know, severe or material deterioration in the labor market and the labor market is soft, it’s not as robust or labor markets that you’d like to see.
As for the constrained labor market, Loretta describes it as being in an “uneasy balance,” that the Fed cannot fix with rate cuts.“Monetary policy really can’t address those issues...we have less immigration, and we have people who are retirees.”
“We have firms not hiring as robustly, and certainly that’s softening. But we also have a fewer supply of workers. She noted that both demand-side and supply-side factors, such as immigration policy and technological advancements like AI, are contributing to this dynamic.
As for the “Next Man Up” to succeed Jay Powell, find out what she hopes the next Fed chair will do. Spoiler alert: Loretta stresses the need for leadership that prioritizes the Fed’s dual mandate and listens to diverse perspectives. “You need someone who’s willing to be a leader, be independent, listen, adapt, update, and then lay out the right path for the committee as a whole.”
See more in our Annotated Transcript below as you listen to what Loretta has to say.
FOMC to focus on prices ahead not the past trend 00:01:40:16
Well, certainly the report that came out today gave them a good picture of where things were before the oil price shock. And it kind of continued the story, which was there’s been continued pass through of the tariffs into goods prices. Right. We’ve seen some better numbers on housing. The housing inflation is coming down because rents are basically coming down for a while. And that’s now showing up in CPI. And we got okay. News on the services excluding housing that didn’t move up, which was you know what people have been looking for. It moved down a tad. So that’s a baseline. But it’s very backward looking.
Oil to impact both sides of Fed Mandate 00:02:35:11
I think what they’re going to be talking about is what are the implications of the war and the oil price shock and the supply disruptions that we’re currently having.both inflation but also for growth. And then, of course, employment, which is part of the mandate. And frankly, they’re not going to really know how long oil prices will stay at elevated levels. So, they’ll use the models to sort of work through that. Now, I can say that the model that the Fed uses - and I think most other macro models generally - would show that an oil price shock, of the kind that we’re talking about and the duration, you know, of a couple of months that isn’t persistent, or that persistent has, some dampening effect on growth and raises total headline inflation for a time, but doesn’t really pass through much to core inflation.
Main lasting impact of oil shock is on growth not inflation 00:03:26:10
And that’s kind of the dynamics of the model. Right. So you might get a, you know, a pretty strong increase in headline inflation for a while. Energy price shock. But in general in six months, eight months that’ll be over. And then, you know, you don’t get much faster from core. And you get some dampening effect on growth.
Still – do not oversell that- the inflation impact is important 00:03:46:04
And so most people would say, well then central bankers will be looking at sort of the effects on growth more than the effects on inflation. But I think in the current context, that probably isn’t the way. I mean, I certainly wouldn’t be looking at that way if I were still on the committee. And I think most committee members will be taking into account the full context of where we are now, which is, yes, and having been elevated above goal for five years.
Demand is still important when there are supply shocks 00:04:14:10
Right. And the fact that one thing we learned in the pandemic is right, that inflation can rise. Even if you think the Phillips curve is slight, if you have supply constraints that are affecting the economy, is you have a sense, you know, enough demand, right? You can get inflation because demand will pass-through. So I think in the context of what the current environment is, that’s kind of the way they’re going to be thinking about it.
The US as an oil exports cushions the negative growth shock 00:04:43:11
So then what are the issues here? One is the growth of may not be as large as it used to be, because we’re now an oil exporting country. Right. So, you know, an oil price shock actually helps some of the producers here. Okay. So the impact on overall aggregate demand in the U.S is less than it would have been like in the 70s, or even the 90s.
Tariffs could make the oil increase bite prices harder 00:05:07:17
So the effect on the growth side is less than the effect on the inflation is… It might be larger than the typical look-through the oil price shock for two reasons. One, I think firms have been bearing the brunt of the higher tariffs. So their margins are already tight… they want to rebuild their margins to make up for the cost tariffs.
Impact on core inflation could be higher than in the past 00:05:32:01
Now this oil price shock on top of it. They may be induced to raise their prices. So the second round effects on the oil price which would show up in core inflation might come a little sooner than in the past. And secondly… Expectations are not as anchored as they were.
Anchoring inflation expectationswill be very important 00:05:53:19
…And that also is something that the Fed will be very concerned about.
Nothing on tap for policy change at coming Fed meeting 00:06:56:16
And they’re not going to do anything next week. Right. And I think they may be on hold longer than that depending on how the economy is. But it’s really going to depend on how the economy evolves. So nothing has changed in terms of Fed’s always looking at the current conditions, what’s the forecast.
Fed must think flexibly 00:07:15:04
Where do they think things are going, what are the risks around that forecast. Things can evolve differently than they think. And then where do you position policy. So this is all going to be about managing policy. So that’s… good position once things become clear. You know that’s one thing we didn’t do that well I was on the committee in the post pandemic.
The Covid mistake was letting policy get to far from ‘right’ 00:07:34:21
Right. We allowed a policy to be far away from where it needed to be. When the inflation became more persistent, and therefore we had to raise rate very aggressively… and what they’re trying to do is make sure they’re in a good position. I think they are. I think they’re in a good position.
Characteristics to look for to support policy moves 00:07:55:11
Let’s think about…what would be the spur right to allowing them to for example, cut rates again. One you’d have to sort of get evidence that <is> convincing evidence on inflation after the oil price shock is continuing to move down…that there wasn’t a disruption in inflation expectations, that they are remaining anchored.
Also job trend performance post oil shock 00:08:21:15 -
And if it seems that inflation has resumed a downward trend and is heading towards 2%… that would be a good outcome in terms of where they want to be. Secondly you want to be able to say the labor market hasn’t deteriorated more. If the labor market deteriorates more, that would spur I think.. they’d have to balance the risks to the inflation part with the risks to the labor market.
Fed to have more of an anti-inflation tilt this year 00:08:48:17
And I think this committee, even with the change in, voters…they have shown that…they take the labor market side of the mandate, maybe, you know, see risks around that are more an inflation risk, at least they did last year. We’ll see, but it’s <inflation> deteriorating more than … that could get them to start moving rates down again.
Financial stability…private credit-could affect policy decision 00:09:13:22
Or if there’s a financial stability issue which with the volatility we’ve seen in the markets, we know there’s some private credit underwriting issues. If that were to evolve into something much bigger than it currently is, you can imagine that a central bank would want to take that seriously. That wouldn’t necessarily be a monetary policy action, but it could be something that would spur them to ease up.
Raising rates is not likely 00:09:39:15
I don’t think that they would be moving to raise rates again. I think the notice would be more if they see inflation maybe not resuming that lower path. They’re just going to hold for longer. I think at this point, unless they saw something that was very different than what we’re expecting on the inflation side, I think they would hold longer and delay <rate cuts>.
Anchored inflation expectations are necessary but not sufficient 00:10:25:16
I’ve always told people yeah inflation expectations. If you think about post-pandemic period, the medium, the short run went up. But the medium and longer runs were always viewed as being consistent with the mandate. And yet we still got very high inflation. So it’s I always tell me, well look, it’s a it’s sort of a necessary condition, but it’s not a sufficient condition to have inflation at your goal.
Inflation expectations do not control inflation 00:10:51:13
It’s necessary to make sure that you maintain inflation expectations, consistent with your goal of 2%. But just because they’re not moving up in the medium and long run doesn’t mean that you can’t get inflation. I think that’s something that people sometimes forget is that, you know, during the pandemic, post pandemic period, we had relatively stable, longer run inflation expectations.
Keys: Anchoring inflation and evaluating supply VS demand 00:11:15:02
They went up a little bit, but they weren’t what people considered unanchored. And yet we still got very high inflation. So I think that they should be doing all they can to make sure they maintain those. But they also have to be evaluating whether aggregate demand is outpacing aggregate supply. And given that aggregate supply is going to be constrained for a while because of what’s going on in the war, I think they have to be very attuned to that.
Fiscal stimulus is in train are price expectations at risk? 00:11:41:01
And on the aggregate demand side, we know that fiscal stimulus is there and it’s coming. So again, they’re going to have to be doing that balancing act, even if they view inflation expectations as being stable. One caveat on the inflation expectations that I think people have to realize is that gasoline prices, which have gone up quite a bit, are one of these, what we call salient prices for determining how consumers evaluate inflation. There’s a lot of research that says, like when those prices go up and it turns out egg prices are another one, and, you know, milk prices or one, those kind of prices that you’re buying on a regular basis that consumers are buying, often those seem to have a bigger impact on inflation expectations. So again, there can be follow on effects from just the impact on other high and oil prices for a time and then coming down that can have a follow on effect that and Spurs other inflationary trends in the economy.
Inflation is probably starting to ease 00:13:55:07
I think the story that inflation is starting to ease is probably right. I think it is hard to read through some of these numbers. And of course we had delayed reports and we’re going to get the PCE report, which is, of course, the one that the Federal Reserve focuses on. We’re going to see that on Friday.
Look back at price data to identify the trend 00:14:14:13
And so I think all that data is going to tell a story. But given what we’ve had since that time…usually we always say…the solutions are backward looking, in particular this time I think it’s hard to do. But backward looking is okay because what we’re trying to do is extract the trend going forward from the data you have.
Hard to identify a trend in the middle of an oil price shock 00:14:34:15
I think what’s different now is it’s going to be hard to extract a trend given the oil price shock, the uncertainty around right, what’s going to happen? I mean, uncertainty itself can have an impact on the economy. And then layer on top of that, the oil price shock, which is impacting whhat people are paying out of their pocket.
Hard to know if policy is on path for 2% inflation 00:14:57:11
It may hold down inflation and other components because demand will be less on those components because people have to pay<more> for their gasoline. But nonetheless, I think all of that makes it very difficult to have much confidence that inflation is on a downward turn back to 2%. If we were starting either at or below right the «level, I would be less concerned. But we’re above the level and we’ve been above for a long time, which is why I would be focusing in on the inflation side right now, unless we get more evidence that there’s a much more, you know, severe or material deterioration in the labor market and the labor market is soft, it’s not as robust or labor markets that you’d like to see.
Too many jobs are in health care 00:15:45:06 -
It’s you know, most of the job gains are in health care. Right. You know, it’s not broad based and it’s reasonable for firms to be very cautious in their hiring because we are in this uncertain environment. And so you can explain what’s going on in the labor market, by some of the uncertainty that is affecting the rest of the economy as well.
Hope the Fed vets its past forecast errors where there were shocks 00:16:47:09
Well, there’s certainly going to look at right, other events in the past where we’ve seen these large increases in the way of shocks. They’re going to look at the duration of those shocks, and then they’re going to look at the impact that was seen in the economy. I’m hoping what they do is also look at what they predicted would happen.
Past performance is no guarantee of future success & vice versa 00:17:07:19
Next week <Fed officials will besitting there saying… our models are telling us that this is the outcome that we expect, right? You know, small downside on growth, temporary increase in headline inflation, little pass through to core inflation. It’d be good if they’re looking at these past episodes not only in what actually happened, but how well did the models capture what happened so that they have a lens to look at, sort of.
How much to trust the Fed’s models 00:17:38:23
How much should we take the model to heart this time? And how much bands are around confidence bands should we have around those forecasts. It’s that forecast that we don’t see much pass through the core, which is a basis for saying, okay, we can sort of look through the inflation impact of the oil price chart and maybe focus on a demand side and see how much demand side downward, you know, affect will have.
Fed must gauge supply and demand 00:19:04:23
It would be a mistake to try to accommodate..if you’re in an environment where demand is outpacing our supply. Right. So in Covid that was what we didn’t fully understand… how strong our demand was. The fiscal stimulus that was in the economy, the, you know, very economy, monetary policy that had been, you know, in effect for a while, aggregate demand outpaced supply.
Raising rates can’t create supply but it can damp demand 00:19:33:09
It was out of balance of supply, and supply was constrained. So you got an inflationary impulse in the economy because we didn’t keep it in balance. We should have been moving rates up sooner than we were…because aggregate demand was outpacing supply and adding supply, adding those pressures. If we’re in that kind of if you’re in an environment where, for example, labor markets are tight, there isn’t a lot of labor supply.
We also have to consider fiscal stimulus 00:20:02:13
That means demand is going up, for example, the fiscal stimulus. Right? Then that can mean things out of balance. And so a supply shock that he constrained supply can have a more permanent effect. And not just a one-off. The fact that you can look through it same way with the tariffs. Right. The tariffs are being interpreted as one-off price level changes.
Fed must keep an eye on actual inflation 00:20:28:16
Right. And then once that feeds through to inflation it’s not inflationary anymore. And that could very well be the way to look at this because we haven’t seen right a big reaction in expectations. But I still think the Fed needs to be looking at actual inflation. And then the projections to make sure that their projections are on track.
Policy mistakes have a way of haunting policymakers 00:20:51:06
Because if they again underestimate persistence, their policy rate could be out of, you know, position and make. It’ll be harder going forward to put it back into position to actually get the inflation policies down.
Swap market to inflation don’t; worry be stable – but no on knows 00:22:10:05
We don’t know how long the conflict’s going to last, right? So it’s kind of hard to make firm predictions about what you think that’s going to have in the oil markets. I know what the market’s even looking at inflation swap data. Right. The markets are saying we’re going to get a temporary increase in inflation. And then if you go farther out right, the inflation swap saying no inflation will be back down.
Oil prices will linger higher, regardless 00:22:30:11
And you don’t have to go that far out. So the markets are interpreting this as temporary. I mean I think there will be should be you know, even if the war is over relatively soon, as the president says he expected to be, it takes some time to ramp up supply again. So, you even when the war ends, there’ll be a couple more months of higher oil prices.
Will there be a lingering prices premium? 00:22:54:11
But I think even longer lasting there may be a premium risk premium in that oil price going forward, because we’ve seen a couple of episodes now where oil’s taken off. Right. We had the Venezuela tax oil taken off. We’ve had this now oil taking off. So I suspect we’ll see an oil premium. Will it be hurtful to the US economy?
Fed would be wise to leave things a they now are 00:23:17:17
Probably not. But all of this depends on really what happens with the conflict and how long the oil is constrained. And we don’t know that yet.I think when you’re <a Fed official> sitting around the table thinking about what a monetary policy position you should take… given what the labor market is in relative balance, it’s not as healthy as I’d like to see, but relative balance between supply and demand and labor market inflation still elevated. They they’d be wise to leave things where they are. Their interest rate were where it’s all until they get more evidence on how things are going to evolve in both employment and inflation.
No recession…but there turbulence of various sorts 00:24:15:12
Yeah, I mean, I don’t think we’re going to get a recession. Before the war things were slower in the fourth quarter firms were reluctant to hire just because of the uncertainty. And <there were> things going on in technology with AI, but they were firing large groups of people. And so if you look at that and it was <what> people call low fire, a little higher.
Positives- tax refunds 00:24:42:00
And then there were some positive things in the beginning of the year. I mean, people will be getting higher, or a lot of people will be getting higher, refunds in their taxes. So there’s some positive things. And then the investment in AI data centers, energy that has to support those data centers, that all remains and they are positive for the economy.
Not enough uncertainty to cause a recession? 00:25:05:18
So again, you know, there was positive signs in the economy. And I don’t and I don’t have any reason to believe that those, you know, aren’t still there. It’s just that there’s a lot of uncertainty. Now, with the war, there’s uncertainty around the tariffs as well. We don’t really know where they’re going to end up. Although the Trump administration is trying to then change… do the investigations necessary to put the tariffs back on under a different basis in the emergency basis. So again, you know, there’s a lot of uncertainty that firms have to deal with that households have to deal with. I don’t think it’s at the level of a recessionary problem, but it’s something that we certainly have to look forward as we, you know, look for evidence of as we go forward.
Scenarios may work better than forecasts…an uneasy balance? 00:26:16:17
I always think scenarios are better to think about when you have these uncertainties. So if you have what I would say was a short lived,the war ends, <war> you know, in the next three weeks, he Strait of Hormuz is reopened, traffic gets through there, and coupled with that we have the labor markets remaining in this uneasy balance. I call it an uneasy balance. And we have inflation remaining where it is. But showing that it’s sort of on a gradual pace down, I can imagine the said would cut in the fall and maybe again in December, if that’s okay, if that scenario, and not necessarily that they should be, but I could imagine them doing that.
Mandate emphasis differences affect policy 00:27:05:17
There’s going to <be> different views. Some people who are really care about the inflation part of the mandate and really want to see more evidence, might be reluctant to cut twice and only want to do it once, but more even zero. But it’s the war last longer. That’s conflict. Even more complicated, because then you’ll see probably more inflationary impulse could end up going into core inflation. But you also may see more demand side effect. Right. And it’s that kind of balancing that’s going to be harder for the committee, because then they really have to make a tradeoff between the inflation part of the mandate and the growth or employment part of the mandate. And I think that’s going to be a much more difficult decision.
Not so much past labor market emphasis as different conditions 00:28:22:03
So I would say differently, I think there has been learning over time and you learn from circumstances. Right. So I think, you know, in the economic circumstances, when we were in, after the great, you know, financial crisis, right, we had inflation being low below target for a long time. Right. And we had a weak labor market that took a long time, right, to come back.
Plus we learned… 00:28:49:13
And I think in that context, the committee was really focusing on the labor market side and also on the inflation side to get it up. But…they were trying to balance those. Well, we learned since Covid.. you can get inflation even if inflation expectations are anchored. Right. If you have demand outpacing supply and supply constraints that are lingering and lasting.
Dual mandate single focus 00:29:16:05
And we’re a series of supply…shocks which we had during Covid. Those can make for a more lasting inflation problem. So again then the focus was on inflation. How do we get inflation down? And you know.. we changed. They changed the framework. To acknowledge that, you know we have to really be caring about inflation being above goal as well as below goal. After coming out of the great financial crisis <so that we would get it righte because we care about the labor market. So I understand why people said the focus was on the labor market. Then in pandemic it became on the inflation. Now maybe it’s going back to employment.
Learning from Covid? Some things monetary policy can’t fix 00:30:02:22
My hope is that the committee has learned from the Covid experience. And while they take into account the labor market side, they really need to be focused on the inflation side. I mean, some of the things going on in the labor market now, monetary policy cannot address, right? We have labor participation down. We have a constrained labor force, right? We have less immigration, and we have people who are, you know, retirees. We have a population that’s older and leaving the labor force. Monetary policy really can’t address those issues. So that’s why people say, like the break even level of monthly payroll growth is a lot lower. The reaction to those low <job> numbers, right, isn’t necessarily lower interest rates, because the labor market is in balance in terms of supply being constrained. And therefore we’re lower and demand lower. There’s nothing monetary policy can or should do about that.
Loretta J. Mester
Loretta J. Mester was president and chief executive officer of the Federal Reserve Bank of Cleveland from June 1, 2014 through June 30, 2024. In that role, she participated in the formulation of US monetary policy and oversaw more than 1,000 employees based at the Bank’s Cleveland office and Branch offices in Cincinnati and Pittsburgh who conduct economic research, supervise banking institutions, promote community development, and provide payment services to depository institutions and the US Treasury. Mester was the 11th president of the Cleveland Fed and represented the Fourth District on the Federal Open Market Committee (FOMC).
Mester began her career at the Federal Reserve Bank of Philadelphia in 1985 as an economist and was executive vice president and director of research at the Federal Reserve Bank of Philadelphia prior to her appointment as president and CEO of the Cleveland Fed on June 1, 2014.
Mester is an adjunct professor of finance at the Wharton School of the University of Pennsylvania and a Senior Fellow with the Wharton Initiative on Financial Policy and Regulation. She is also a Senior Scholar at the Griswold Center for Economic Policy Studies at Princeton University. Mester has also taught in the undergraduate finance and MBA programs at Wharton and in the PhD program in finance at New York University.
Mester is a member of the board of directors of Renaissance Re and of the Haverford Trust Company, a member of the advisory council of the Visa Economic Empowerment Institute, and a contributor to CNBC, the business and financial news network.
In addition, she is a trustee of the Cleveland Clinic, a trustee of the Musical Arts Association (Cleveland Orchestra), a director of the Council for Economic Education, a founding director of the Financial Intermediation Research Society, a member of the CNBC Global Financial Wellness Advisory Board, a member of the Global Interdependence Center’s College of Central Bankers, a fellow of the National Association of Business Economics, a member of the senior council of the Central Bank Research Association (CEBRA), a member of the advisory board of the Financial Intermediation Network of European Studies (FINEST), and an editor of the Journal of Financial Services Research. She is a member of the American Economic Association, the American Finance Association, and the Econometric Society.
Mester was born in Baltimore. She graduated summa cum laude with a bachelor of arts degree in mathematics and economics from Barnard College of Columbia University. She earned MA and PhD degrees in economics from Princeton University, where she was a National Science Foundation Fellow.