(Bloomberg) -- Federal Reserve Bank of Cleveland President Loretta Mester brushed aside concerns over a flattening yield curve while expressing some worry over elevated stock market valuations, saying both were reasons for continued interest rate hikes.
In an interview Thursday with Bloomberg News in Washington, Mester argued that low long-term interest rates and high share prices make for easy financial conditions and provide fuel to an economy that is at or beyond full employment.
Some analysts have expressed an opposite worry, saying that the narrowing gap between yields on two-year and 10-year Treasuries may be a harbinger of a weaker economy. That differential has declined to about 62 basis points from 129 basis points when the Fed began raising rates in this tightening cycle in December 2015.
An inverted yield curve has been a reliable indicator in the past of impending recessions. When short-term rates are higher than long-term ones, it’s not profitable for banks to lend, constricting credit and thus hurting the economy. Yield curves also tend to invert when the Fed is aggressively raising short-term rates to try to contain inflation it judges is too high.
That’s not the case now, Mester said, with inflation below target and the central bank only slowly lifting short-term rates.
“I just think long rates are going to go up given where we are in the economy and given where we see the economy going,” she said. “But this is another reason why we need to keep raising up the short rate. These financial conditions are accommodative.”
Mester was less sanguine about U.S. equities, which have hit multiple record highs this year, and other asset markets.
“It’s not a huge risk or an imminent problem, but something we need to be worried about,” Mester said. “It’s one of the risks I feed into why I think we need to be moving interest rates up.”
Mester, head of the Cleveland Fed since 2014, has been a consistent advocate among Fed officials for gradual rate increases in spite of weakness this year in inflation readings. A voter on the policy-making Federal Open Market Committee next year, Mester dissented twice in 2016 in favor of hikes at meetings when the panel held rates steady.
While unemployment has fallen to a 16-year low of 4.1 percent, the Fed’s favorite gauge of inflation rose 1.6 percent in the year through October, below the central bank’s 2 percent target.
“There’s a compelling case to keep this gradual increase in interest rates going,” she said. “I’m not as worried about the inflation numbers, even though they are low relative to our goals.”
The FOMC is scheduled to meet Dec. 12-13 in Washington. Pricing in contracts for federal funds futures imply that investors overwhelmingly expect the Fed to raise its benchmark rate by a quarter percentage point, to a range of 1.25 percent to 1.5 percent.
Mester said information from business contacts in her district showed firms are responding to labor shortages with increases in benefits and wages. That bolsters her forecast for inflation to return gradually to 2 percent.
“The anecdotal evidence is certainly consistent with wages going up,” she said. “Whether that will translate into the aggregate numbers, and when, is hard to predict.”
She poured cold water on the idea that the Republican tax package making its way through Congress will boost U.S. economic growth markedly on a sustained basis.
Mester said she’d already incorporated some small positive impact into her economic forecast from expected fiscal policy changes, but won’t be changing the forecast she submits at the December FOMC meeting based on the tax plan that is coming closer to passage.
“I don’t believe what I see is going to have a major impact,” she said. “Most of the work I’ve seen about changes in the corporate tax rate doesn’t really support this big increase that some people are predicting for potential growth.”
Mester, who served as director of research at the Philadelphia Fed for 14 years before taking the top job in Cleveland, was also skeptical that American workers would see any significant gains in wages.
“It’s really going to depend on productivity growth picking up,” she said. “Productivity will pick up, but I don’t have a strong feeling that it’s going to pick up to the extent that we’re going to see wage growth of 3 to 4 percent.”
She predicted annualized wage growth would climb to 2.5 percent to 3 percent within the next two years. The Bureau of Labor Statistics reported average hourly earnings rose 2.4 percent in the year through October.
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