— But Must Assess Impact of Recent Market Turmoil Before Making Sept Rate Decision

By Steven K. Beckner and Karen Mracek

JACKSON HOLE, Wyoming (MNI) – Cleveland Federal Reserve Bank President Loretta Mester said Saturday the U.S. economy is strong enough to bear a modest increase in the federal funds rate, but nevertheless said she needs to assess the impact of recent financial market turmoil before deciding whether to support a rate hike in September.

"I’m going to use the time between now and the meeting to formulate my forecast and process the incoming information," Mester told MNI in an interview on the sidelines of the Kansas City Fed’s annual symposium here.

"But my view is that the economy is – the fundamentals are – solid and that the economy can handle a modest increase in interest rates," she added.

Though she was reluctant to specifically endorse a Sept. 17 rate hike, Mester said the U.S. economy is close to full employment and says she is already "reasonably confident" that inflation will return to 2% over "the medium term."

She thereby seemed to be suggesting the Fed’s policymaking Federal Open Market Committee has already fulfilled its two conditions for starting to raise the funds rate from nearly zero: "some further improvement in the labor market" and becoming "reasonably confident that inflation will move back to its 2% objective over the medium term."

However, Mester, who will be a voting member of the FOMC next year, said she needs to "take on board" recent international and financial market developments, including the Chinese economic slowdown, plunging oil prices, further dollar appreciation and the stock market sell-off.

"Of course you’ve got to consider the volatility in the markets," she said. "Certainly that’s something you need to look at – what the cause of the volatility was," as well as reassess global growth and Chinese growth and determine the implications for the U.S. economic outlook.

Mester said she is assessing the impact of those developments as she prepares to submit a revised forecast for the quarterly Summary of Economic Projections which the FOMC will publish after its September meeting. She noted there will be more important economic data released before then, including the August employment report Sept. 4.

"I think it (market volatility) does increase downside risks, but at this point I want to look at all the information that comes in," she added.

Despite increased downside risks from abroad, she predicted continued "above-trend growth" with further reduction in labor market slack and gradually increasing inflation. She expects growth to be between 2.25% and 3% over the next year or so.

Asked about the timing of a rate hike at later meetings if the FOMC doesn’t move in September, Mester said an October liftoff is possible, adding "every meeting is a live meeting."

But she downplayed the importance of moving away from the zero lower bound in any particular time frame: "A meeting or two here or there is not a significant factor for the macroeconomic outlook."

"We’re always trying to calibrate policy to current economic developments and our outlook for the economy, so again if we delay too much that might be a factor, but a meeting or two is not material for the macro-economy."

In a Friday afternoon interview with MNI, former Philadelphia Fed President Charles Plosser, who Mester used to advise, warned the Fed could lose credibility or appear to be market driven if the FOMC further delays a rate hike. But Mester did not seem overly concerned on those scores.

"I think the Fed is a credible institution," she said, but the FOMC has to review and assess incoming data and recent developments and determine "how they change risks around the forecast."

The 17 FOMC participants will "all come in with our views," she said, "have a fruitful discussion" and "come to a decision."

As for the the Fed being perceived as overly responsive to the markets if the FOMC delays liftoff, "financial conditions matter for the forecast," Mester said.

"Certainly you don’t want to be reacting to short-term movements in the market," she continued, "but you do have to take on board… how (financial market volatility) affects risks to our outlook."

"We need to process that and come to terms with it," she added. "We’ll look at all the incoming information and assess it and see how it affects our outlook."

One piece of Mester’s outlook that might change with her submission to the Summary of Economic Projections is the longer run inflation outlook.

She expects lower oil prices and a stronger dollar will have only "transitory" influences on her inflation outlook.

But, she added, it "may take a little bit longer to reach 2%" inflation, Mester said, adding her previous forecast had been for a return to target by the end of 2016 or early 2017.

When oil prices dropped beginning in the summer of 2014, "inflation measures came down," she said, "and then started to stabilize as well."

With the most recent drop, which has seen oil prices fall below $40 a barrel, "I think with the further drop, we’re going to see that pattern again."

But, Mester added, above trend growth and continued positive labor market developments "are the countervailings, and that’s what gets my forecast of inflation back up to 2%."

Also, "inflation expectations remaining very stable is very important to my forecast," she said. "In times of a lot of volatility in the markets, I think it’s very hard to infer inflation expectations from the market-based measures, so I rely on the survey based measures and to my mind, they have been relatively stable."