The Maestro of Macroeconomics

The Maestro of Macroeconomics

Cleveland Federal Reserve President Loretta Mester meets with PACB to discuss redeveloping the rustbelt, worldwide economic volatility, and the connection between Opera and economic calamity.

Loretta Mester

Nick DiFrancesco (ND): Thank you for taking time and sitting down with us. You’ve been at the helm of the Cleveland Federal Reserve for just over a year. What are some of the aspects of the position that surprised or challenged you?

President Loretta Mester (LM): Before coming to Cleveland, I had served as the director of research at the Philadelphia Fed, beginning in October 2000. In that role, I had attended many meetings of the Federal Open Market Committee (FOMC) in Washington D.C., but as a policy advisor, not as a policymaker. Upon my appointment as president of the Federal Reserve Bank of Cleveland, I moved from a seat behind the table to one at the table. While that move was only a couple of feet in terms of physical distance, the real distance is far greater. I feel very honored to have been chosen to lead the Cleveland Fed. I feel a great sense of responsibility in contributing to the Federal Reserve System’s important work of promoting a healthy economy and stable financial system.

The economy has made significant progress since the darkest days of the global financial crisis and Great Recession, supported by extraordinary monetary policy accommodation. As the economy returns to more normal territory, monetary policy will need to begin returning to more normal territory as well. Our monetary policy decisions are dependent on economic developments and their implications for the outlook – that’s what we mean when we say our policy is “data dependent.”

We face the important challenge of assessing economic conditions so that we can ensure that our monetary policy is appropriately calibrated. We collect and analyze economic and financial data, but because much of the data come in with a lag (not only that, but the data about the past are often revised), it is also very important to talk to bankers and other business leaders in our region to learn what they are seeing on the ground. Because monetary policy affects the economy with a lag, we also need to use models and other forecasting techniques. It is an understatement to say that the extraordinary economic developments in recent years have presented challenges to our models and forecasts. Economists at the Federal Reserve Bank of Cleveland and throughout the Federal Reserve System engage in research to help us constantly improve our methods. I use the information I gain from our business contacts, the economic and financial data, and our analysis to help inform my views of the regional and national economy. I provide my views on the economy at FOMC meetings and I also listen to the views provided by my colleagues around the FOMC table. Hearing what others are saying about their Districts and the broader economy is an important ingredient in arriving at my policy view.

The financial crisis underscored the need to monitor not only economic developments but also financial sector developments and potential risks to financial stability. I believe the Fed has made important strides in building our capabilities in this area. With interest rates having been at zero for a sustained period, the FOMC is carefully monitoring financial markets for any signs of increased risks to financial stability from excessive leverage or from investors taking on risks they are ill-equipped to manage in a search for yield. So far, we do not see a threat to financial stability. In addition, the banking sector’s return to health since the Great Recession, including higher capital levels, has made the financial sector more resilient.

ND: The 4th District encompasses many communities in Pennsylvania, Ohio, West Virginia and Kentucky that have suffered economic setbacks and are categorized as “rustbelt cities.” What tools are available to those communities to experience recovery and become vibrant hubs of economic prosperity?

LM: The Fourth District economy, like the rest of the nation, has improved substantially since the Great Recession. But it faces longer-run challenges. The share of jobs in manufacturing has been falling since the mid-1990s; the economy is becoming more reliant on service sector jobs, including those in education and the medical sector, so-called “eds and meds.” This transformation means that there is a greater return to developing human capital. The number of low-skilled jobs in manufacturing and other areas of the economy is shrinking. The unemployment rate for those with a college degree is less than half what it is for those with only a high school diploma. And the difference in wages between those with a college degree and those without, the so-called skill premium, has widened substantially over time, more than doubling since the 1970s. Over a lifetime, in present value terms, a college graduate can expect to earn nearly twice as much as a high school graduate.

This suggests that we need policies and programs to ensure that people can gain the necessary skills to enter and remain productive members of the modern labor force. Some interesting research has found evidence of knowledge spillovers: less-educated workers benefit in the form of higher wages from working in areas populated with more-educated workers. Another study found that cities with more highly educated populations experience lower unemployment rates, higher productivity growth, and higher growth in entrepreneurship than what would have been predicted by considering only individuals’ educational levels. This means education appears to be a valuable investment not only for the individual but also for the communities in which people live.

Encouraging entrepreneurship is another promising path. Here, our region is not keeping up. The Kauffman Foundation recently ranked Pennsylvania 48th out of the 50 states in terms of startup activity; Ohio was ranked 37th. But the region has some excellent colleges and universities. Partnerships between universities and entrepreneurs have the potential to promote innovative ideas that can be turned into profitable businesses and, ultimately, jobs. Retaining students in the region after they graduate will also help create a more-highly skilled workforce.

Loretta Mester

ND: You’re a member of the Federal Open Market Committee (FOMC) which has received a great deal of media and public attention regarding interest rates. What has been your experience working with other Fed Governors as you collaborate and work towards growing the US economy through prudent monetary policy?

LM: The seven members of the Board of Governors (currently there are two openings) and 12 Federal Reserve Bank presidents all participate in FOMC meetings, led by Chair Janet Yellen. As you said, it is a collaborative process. It is also a very collegial group. Each of us brings a different perspective to the table, which makes for a very productive discussion of the issues leading to a consensus on monetary policy. I very much value hearing the views of my colleagues as we work toward assessing economic developments, the outlook, and the risks to the outlook. The decentralized structure of the Federal Reserve System is one of its great strengths and one worth preserving. It helps ensure that Main Street perspectives are considered when we set national monetary policy.

ND: There has been concern about the liquidity situations in Puerto Rico and Greece and the potential impact on the US economy. What are your thoughts on the development of these issues and do you think there will be any negative impact to the economic recovery of the 4th District or national economy?

LM: The situation in Greece remains unresolved. The economic circumstances there are very painful for the Greek people. But I expect the situation to have only a limited effect on the U.S economy. Our direct exposure via trade is limited and our banks have little exposure to Greek banks. In addition, Greek debt is held mainly by the public sector rather than private-sector investors, and the European Central Bank has tools to contain spillovers to broader financial markets. Although there has been some volatility, the reaction in bond yields in other European countries as well as in the U.S. has largely been subdued.

I am not expecting the fiscal problems in Puerto Rico to spill over to the broader U.S. economy. Credit conditions in the municipal bond market have remained stable in the wake of Puerto Rico’s announcement that it may need to seek restructuring of some of its debt. The exposure of tax-exempt mutual funds and money market funds is fairly limited. Of course, my colleagues and I on the FOMC continue to monitor the situation.

Another risk you did not mention was the weak growth in China, and volatility in its stock market. My forecast does incorporate weakness abroad, including China, although the magnitude of the slowdown in China remains uncertain.

Acknowledging the risks, my outlook continues to be for continued expansion in the regional and national economy, further improvements in labor markets, and a gradual firming of inflation over time.

ND: In the most recent edition of the Federal Reserve’s Beige Book, the summary for the Fourth District indicated strong commercial and industrial lending, as well as sustained hiring of risk managers and commercial lenders. This was also noted in the January and April summaries. Based on what you’re hearing from bankers, business owners and academics in the district can you extrapolate further on if these trends will continue through the second half of the year?

LM: There has been a steady increase in demand for business credit in the region. Overall, my forecast is that the Fourth District economy will continue to expand and labor markets will continue to improve. Household and business balance sheets have improved substantially over the expansion, and with the economy on firm footing, I expect that demand for business credit in the region will continue to rise.

That does not mean there aren’t challenges for the banking industry. Our banking contacts are telling us that there is mounting competition from nonbank lenders and the regulatory environment remains a challenge. Banks play a key role in providing valuable credit, risk-management, and liquidity services to businesses and households. The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in 2010, includes a number of provisions to strengthen the supervisory and regulatory framework, with the goal of promoting a more resilient financial system. Consistent with the provisions of the act, the Federal Reserve and other federal banking agencies are taking a tiered approach to banking supervision and regulation. This approach recognizes that the risk a banking organization poses to the financial system is likely to vary according to its size, range of activities, and complexity, and so supervision and regulation should vary as well. For example, individual community banks are subject to regulatory oversight to help ensure they remain sound and able to extend credit and other services to their communities. But the actions community banks take do not typically impose costs on the rest of the financial system or create the kinds of contagion that can put the entire financial system at risk. So community banks shouldn’t be subject to the same types of macroprudential rules and supervision aimed at the systemically important institutions.

Loretta Mester

ND: The Federal Reserve Banks of Cleveland, Philadelphia, and Richmond recently hosted a Policy Summit looking at various issues surrounding housing, human capital and inequality. What were some of the major takeaways from this collaborative effort and are there action steps we can expect to see taken in the near future?

LM: The Policy Summit is an excellent example of the role the Fed plays in bringing together people to share their different perspectives with an aim toward developing more effective economic policies. More than 300 researchers and practitioners from around the country attended the two-day Policy Summit in Pittsburgh, discussing various issues related to improving our communities, from access to credit to workforce development. They shared their experiences with what works and what doesn’t work. They presented research that has the potential to lead to better programs and policies. There are great synergies to be gained by bringing together researchers and practitioners. Research informed by the people who are actually on the ground working in communities and running the programs can help identify which strategies and policies are likely to be most effective.

The Policy Summit underscored to me that there are no short-run, magic-bullet solutions. It would be a mistake to expect quick gains and so to conclude too early that a program isn’t working. When we are talking about investments in people and neighborhoods, it can take years before these investments yield a significant pay-off. At the same time, it is very important that there be rigorous program evaluation. Funding is scarce and needs are plentiful. Improving our knowledge about which programs are effective and why they are effective will help ensure that we design the best programs. We’ll be able to help the most people and have confidence that our investment in these programs is money well spent.

ND: I know you keep an extraordinary schedule, but can you share a little bit with us about your personal life? What do you like to do in your spare time?

LM: I am an opera fan. My husband and I have continued our subscription to the Metropolitan Opera in New York, which we have held for many years. I try to listen to and attend operas regularly in the U.S. and abroad. I enjoy other kinds of classical music as well and feel very fortunate that Cleveland has a world-class orchestra.

A few years ago when I was attending Wagner’s Ring cycle at the Met, it struck me that it was a story of the financial crisis. Wotan essentially overinvests in housing. He’s building Valhalla, a new residence for the gods that they really can’t afford. He signed a very poor contract that he then has to renegotiate and steal gold to pay off. This sets in train a whole set of unintended consequences.

Today, I would liken the state of the economy to Mozart’s Magic Flute, which tells how mankind moves from a state of chaos and, through a series of trials and tests, emerges into a world of enlightenment and reason. Over the six years since the crisis, we have certainly gone through a series of trials and tests. I would like to think that we have learned a lot from this very difficult period. We have become more enlightened – but part of that enlightenment is an understanding that we have to remain humble and that we need to continue to learn. Still, I do believe that the economy and the financial system have emerged from chaos, and both are more resilient. Our task, now, is to work to keep them that way!

This exclusive interview can be found featured in the September 2015 issue of Transactions. Not a subscriber? Visit the Transactions page on this website or call PACB at 717-231-7447 to start receiving the magazine.