Interest-Rate Policy and the Evolving Economy

Cleveland Fed President, Loretta Mester, stated on Wednesday that the current interest-rate policy is in a "good place" and has flexibility to move in any direction depending on how the economy develops. Speaking at Loyola University Chicago, Mester emphasized the importance of monetary policy being adaptable to unexpected changes if they were to occur. She stated, "monetary policy will need to be nimble and respond appropriately to the evolving outlook and to the risks to achieving both parts of our dual mandate. I believe the current level of the funds rate positions us well to do that."

Traders in derivative markets are anticipating that the Federal Reserve will maintain steady rates at their next meeting on Dec. 12-13. Mester's comments align well with these market expectations.

Looking ahead, the market is also predicting rate cuts for next year. Consequently, the 10-year Treasury yield has declined to 4.29%.

During her speech, Mester did not explicitly address the possibility of rate cuts. Instead, she emphasized that the decision on whether the fed funds rate should be increased or remain restrictive depends on how the economy performs, changes in risks, and progress made towards achieving both price stability and maximum employment - the dual mandate goals.

It is worth noting that Mester will become a voting member of the Fed's interest-rate committee next year. However, she recently announced her decision to step down from her position when her term expires in June.

The Fed's Approach to Financial Stability

Fed Chair Jerome Powell has announced that the Federal Reserve will be conducting a comprehensive review of its interest-rate policy framework in late 2024. This review presents an opportunity for the Fed to explain its approach to setting interest rates while ensuring a stable financial system.

Loretta Mester, an influential figure within the Fed, suggests that this review should focus on the interaction between monetary policy and financial stability policy. Mester believes that the revised framework should provide greater clarity on how the Federal Open Market Committee (FOMC) considers the potential impact of monetary policy on financial stability risks and how those risks shape their decision-making process.

Mester further argues for a redesign of the stress test conducted on the largest banks. She suggests that this test should be transformed into a more effective countercyclical capital tool. Under this new design, banks would be required to strengthen their capital buffers during periods when they are better equipped to do so.

Additionally, Mester advocates for the implementation of the countercyclical capital buffer. This buffer would compel banks to maintain higher levels of capital during periods characterized by high credit growth.

By adopting these changes, the Federal Reserve aims to enhance its ability to address financial stability concerns effectively. This proactive approach reflects their commitment to maintaining a resilient and secure financial system.