Surveillance: Fed's Mester Supports March Hike

Of course, with Michael McKee and with Jonathan Farrell in the great precursor to what we'll hear from Jerome Polier in about an hour. We do this with the markets churning this morning. Our Jonathan Farrell were the president of the Cleveland Fed, New York City especial Welcome to ot CV and radio audience worldwide. Bloomberg's My McKey alongside us. Happy to say joining us both Cleveland Fed President the Randomester President Memester. Always fantastic to catch up with you.

You know the setup right now, We've got Deutsche Bank City JP, Morgan Goldman all calling for rate hikes in March, some of your colleagues doing the same. What obstacles the left of any for making a move that suit. Well, you know, the economy is on a really good track. The inflation numbers are high. It looks now that inflation

is more persistent. I'm going forward early in the pandemic. Earlier, you know, in the last year, a lot of those rate price increases were really on things that are really tied to the reopening of the economy and the supply chain.

Now those price increases of broadened. So if the economy in March looks like it does today and the outlook is similar, and of course there's uncertainty around that, but if it does, and I would support moving the funds right up at that meeting and starting to move back from some of the extraordinary accommodation we needed earlier in

the pandemic. And you know, I just want to point out that even when we make that first rate move, whenever it is that's not really policy tightening, accommodation is still going to be really high at that point. So you know, I think that the case is really strong to begin to wind back some of that accommodation. Well, that raises the question for our friends on the trading floor of how far how fast and where do you stop? Bill Dudley says you probably need to do four or

five rate moves this year. You've long been an inflation hawk. How far do you think you need to go? Well, I can tell you in that December set submission, I had three pencil in for for this year and a few more over than you know next the trajectory. But I also want to point out that you know, we're gonna have to see how the economy does over time before we can say for sure how many rate increases are needed. You know that there's still a lot of

uncertainty round the outlook. There's uncertainty about how the pandemic plays out. As we've seen each new bariat, the economy has really navigated it in terms of the economic outlook. But right now, you know, we have to say that we probably need to recalibrate our policy stance because inflation is well above where we need it to be. The employment markets, you know, labor markets are tight from the

standpoint of a policy relevant framework. Do I think we'll see labor force participation move up somewhat after we get beyond the pandemic, of course, but I don't think we can ignore the shorter run or medium run tightness in that labor market. So I think we're in a good place to move policy, and you know, we'll have to see how that affects the economy going forward and the

other factors affecting economic growth and employment going forward. Well, speaking of moving policy, the Fed's statement of principle says that the interest rate, the FED funds rate, should be the primary tool. But you also have a lot of bonds on the ballot. Cheat how does quantitative tightening to use the market term fit into your thinking? How much would that be worth uh in terms of additional tightening and when do you think that should be done, if

at all? Yeah, So, I mean we have a little bit of a playbook from the last time, but I think this time is different in the sense that we basically have a much larger balance sheet than we did because we had to do those asset purchases at the start of the pandemic because of financial market conditions being the disruption of the financial markets, we really needed to make sure that the financial markets continue to function. Now

that additional liquidity is serving as a accommodate of policy tool. Um, we also have a much stronger economy now, so you know, I think we'll be able to to allow the balance sheet to run down much faster than we did last time because of those two factors and adjusting you know, how far to go and how We're still considering that, but I do think that it's good to look at sort of the policy tool to interest rate as our main tool, but to take into account that we also

are going to allow the balance sheet um to to to run down. I mean, we double the balance sheet over this pandemic period, and I think we can bring it down um also to support less accommodate of monetary policy stance. And we'll have to see. I mean, frankly, there's a lot of estimates out there what happened the last time we did quantitaryated eat you know, easing and

then tightening. But the pandemic is a different environment as we've seen the whole time, right, I mean, you know, we don't still know kind of what those effects will be and we'll have to keep monitoring that. But that's kind of what we do always when we're doing monetary policy. We always sort of think about we take an action

that we look at the data. We're very data dependent. Um, we're very you know, looking at the current economy and then the you know, what's on the horizon for the outlook, and then we take into account the risk around that outlook, and then we recalibrate our policy. And I that we're going to do that this time. I'm sure President message just to get some more clarity on that, I think

this is important. Do you think balance sheet reduction is something that runs passively in the background alongside decisions you make separately on rate hikes or is it something that supports the right hike effort? Mike and I are trying to consider trying to work out whether the balance sheet reduction reduces the need for further rate hikes at some point as well. How do you think about that dynamic. Is it's something that runs off in the background passively

or something that you think about together alongside interest rate hikes. Well, I I'm gonna answer your question the way You're not gonna like both, right. I Mean, my kind of way I think about it is I'd like to sort of set sort of a path for the balance sheet, you know, communicate that in advance from the markets that will you know, reduce accommodation and then we'll use our policy tool, the fit fund rate, as our active tool. But you know, sometimes we have to recalibrate, as you saw we did

that in No we're in the December meeting. We started with you know, uh, tapering of the asset purchase program we announced in November, and then in December of the committee sped that up and and that may have to happen over this period as we calibrate, But in general, you know, my approach will be come up with what we think is the right plan for that balance sheet, how that happening, and then use the policy tool as

our main tool of monetary policy. A couple of times in this conversation already have used that phrase reduced accommodation when we heard from Bill Dundley yesterday talked about the fantasy land of Delvish forecasts at the Federal Reserve. And I just want to do we need restrictive policy at the Federal Reserve? Do we need to get away from talking about reducing accommodation and talk about outright having a restrictive policy stance. So I don't think we need to

do that at this point. I think that that's got to be on the table of you know, where's the endpoint. But you know, when we do our steps, it's three years away. And as we've seen, you know, the economy can change in ways um that are very unexpected. So again, at this point, I think it's really important that we

take actions to bring inflation down given the environment. And you know, a lot of times people think, oh, you're either for maximum employment or for you know, lowering inflation, and I don't see them as opposing one to drink again, how can you reduce inflation without a restrictive policy stance with that tone of financial conditions, How does that work? Right?

Because the markets are reacting, right, So we've already seen some tightening and financial conditions in the market, and so you know, I think what we have to do is we have to bring our polishy rate in line with the economy and where we wanted the inflation rates to go, and we're gonna have to take actions to do that.

So right now, if you look at long term inflation expectations, you may take some comfort in the fact that they're basically maybe a little elevator butt around our cheaper same goal. I don't think that much comfort in it because that's based on, you know, the taking appropriate actions. So it's incumbetent on us to take those actions. And I think we're in a good place to do that now. Well, you've said that we need to see how the economy develops before you know what you're going to have to

do in total. But the pessimistic view expressed by a lot of people, you know who they are, is that you've waited too long, you're behind the curve, You're gonna have to move too far, too fast, and as the phrase goes, you'll break something, maybe send the economy into recession. How do you reassure people that won't happen, given that the Fed's track record in this area isn't very good. Well, I don't know whether the track record is that bad.

I mean, I think that the last cycle proved that we kind of navigated that pretty well and that we had a very very long expansion, right, a historically long expansion. So this is a pandemic environment, new things. We're gonna look at the data. We're gonna make sure we're focused on meaning both of our goals and maximum employment and inflation. It's it seems clear to me now, and inflation is too high, and labor markets are strong, and we need

to take action and ask the economy moves. We will take appropriate action to make sure that we're doing what we can to keep the economy on a positive trajectory, and that means taking actions to bring inflation down without right harming the positive trajectory of the economy. And that's gonna be a challenge, There's no doubt about it. That will be a challenge for us. But that's what we do, that's what we're charged to do, and that's what we'll

be doing. Let me shift gears a little bit and anticipated question from Elizabeth Warren, Massachusetts Senator to the FED Chairman J. Powell. Today, we've seen two FED bank presidents resigned. We're now seeing the vice chairman resigned early. Does the FED have an ethics problem? I don't not believe we have an ethics problem. I think what happened was there was illumination on things that gave an appearance issue. Right, they were technically correct in terms of the rules, but

it was the appearance issue. Um that share and the FED are taking actions to strengthen the rules upon which we have to abide, and I think that is addressing the situation. I do not believe there's an ethics issue at the Federal Reserve Presidents. The final question from us every cycle for the past few cycles, the feed funds right has piked at a lower level. Do you think the dynamics are now in place with this economy? They give you reason to think that might not be the

case this time. Well, I mean partly, that's where what we've just been talking about is how far do we need to go in order to re calorie policy to meet our two mandated goals. But I also want to point out that the factors that held down inflation over the last cycle, globalization, technological change, demographics, there's probably still

in play in the economy. It's just that they've been swamped by the supply chain issues, the high accommodation that's in the markets right now, um labor market issues that keep people out of the labor market. So all of those things right are now front and center. Eventually will probably get back to a low interest rate environment. The red messed up the Cleveland Fed. President, Thank you very

much for being with my McKay and my staff this morning. Well, we really need is someone who knows negative celsius and like you get the rollodex out and there's only one name in surveillance land, and that's David Harrow, Packers fan and David in two thousand eight Giants Packers you were there and it was a negative thirty one celsius windshill. How cold was that game? That was pretty cold? And you know you have to cover everything up and make sure that as you're drinking beer that you had in

your face mask. You needed a little thing for you drink your beer because the beer, of course keeps you warm. Tw notes and you have to start the day with the broad worst because that is your fuel. So the beer is anti freeze and the fuel is the problems problem. Thank you for that analysis from balmb in Chicago this morning. David Harrow on international investment, the fuel is a weaker dollar. Are you going to get international equity performance singularly because

you need a weak dollar. You need a weak dollar to make it work. Now it's it's certainly been a headwind by the way. Strong dollar has been a definite headwind over the better part of the decade really, and now that the dollar seems to have peaked, perhaps that we could get some reversal of this, but that's just one of the factors that has impacted international returns has been the strength of the dollar. It has been a headwind.

I expect that will probably be a tail one. But I think more importantly areas like Europe coming out of the pandemic ending the negative real interest rate, the negative interest rate experiment will be even bigger drivers, especially given the valuation differentials between say, European equities and the rest

of the world. So David, let's push that forward into your call on European equities, especially as we get a headline this morning that the World Health Organization is saying the O macron may in fact more than half of all Europeans within the next couple of weeks, based on

how much the transmission rates are increasing. Is your view that Europe will actually emerge from this more quickly, will actually have a lower interest rate policy for longer, and will actually allow equities to outperform in a way that

most people are not expecting. Yeah. I think what will happen is this uh amicron rolls through the world, and it kind of seemed to have triggered first in Europe compared to the US UH and as as you know, the Spanish Prime Minister said today, we've gotta stop stop looking at this as a pandemic and start just learning to deal with this with the flu. And eventually the rest of the world will get this message. I looks like China is going to be the last one to

get this message. But what will happen is is they reopen the economy and you you finally are getting this is synchronized reopening. This will be a major boost to the European economy as it will be to the global economy, and European businesses really have a heavy export component to them, and so as the global economy reopens, I think you will expect to see the European economy is almost a warrant on global economic growth because the heavy export influence

it has on their economy. And in the meantime, you have had these negative interview rates almost since post the financial crisis. I do believe this will be coming to an end as well as the global financial system is fully capitalized. Uh you know, the reserves that have been built up over the decade can now the money earned can now be used to invest, to grow to give

the owners. Um So I do believe that it's going to be a better environment that the tail winds hurting investors in Europe and outside the United States, or the headwinds hurting them become So, David, is the way to get the most out of that call to go into European banks. I think that's one way. That is one way.

I think this is has been for a long time and times in the kidney because we've been stubbornly attached to these why because the price is low, and even despite those macro headwinds, they've been able to grow earnings now, albeit at a slow rate, but you know, you have been able to see acceptable business performance despite the very poor macro conditions. Now these macro conditions are changing, and so I believe you will see even a faster build

up of capital. Instead of that capital having to stay on the balance sheet because of reserve requirements, they're in to be able to use that capital. So you're gonna see an increase in the velocity of money. And this is exactly why the central banks can't send David, we gotta turn to European banking. It has been a horrific two thousand twenty one from management all sorts of stories. You've actually been knee deep in this and very visible

and I'm sure at times invisible as well. Is European banking management becoming more Anglo American where they will really adapt to shareholder pressure. You know, I was just talking to your your very good reporter and covers this, Yeah, Jehan Heinrich Forster by the way, and he you know, I think it's improved greatly. It is if you look, I look across our whole needs UH in Italy and TESSAs al Polo and France b NP. I mean, two of the best banking CEOs, I would say in the world,

and UH and and leading those organizations. Credit Suite, of course, which is struggled, really really struggle. Come on, David, David, I gotta cut you off. Let's get to the chase, David Harrow. Does Credit Sweeze have to be put out of its misery? You know what happen has to happen at Credit Sweets is they have to allow change to happen via the new chairman, um Antonio ortez O Sario. If he is very capable, he stabilized and repaired Lloyd's.

He's the exact answer to their problems. Now. To be honest, I think this is their lot. This is the last chance you. He is the answer to their problems. You need organization, you need discipline, you need a culture of risk control. These are exactly what he brings to the table. David, and I think that if he's not allowed to do this, and if they pick on him over this quarantine stuff, then you then it should probably be broken up. So

as an investor, how much time are you giving them? Well, you're being paid to weight in essence because the price of the business is fifty or sixty of book value. When I run properly, it should be a double or triple that. So we will be patient as long as we're seeing progress, and then if if it becomes unfixable, as Tom you know and suggested, Um you know, by the way, many parts of the business are operating just fine, and unfortunately those many parts of the business. Azzi Grubel

said this. You know, it's really simple. Banks make money, but the object is to keep it after you make it, and in Credit Sweezes case, they didn't or have not been able to keep all of what they've made because of poor risk control and poor legal and compliance etcetera, etcetera. So if you can fix these things, all that money that has been made in the past, that has been fritted away two finds and two losses will become gains for the shareholders. And I think this is what's important

is you know the engine has been producing income. It's been coming in the front door, unfortunately because of sour leadership and management. And I think you know it's been no secret. I think the past chairman of the business, who has been there over a decade, presided over all these legal incidents and all these marketing fractions. Now that you have proper top leadership at the top of the organization, I believe that this this income that is generated can

be captured. It's David, you mentioned a word that unfixable. What does unfixable look like? How do you know it when you see it? When you continue to see losses and infractions and a lack of executional excellence and a lack of discipline. You need discipline, and especially in financial services where you have in many cases translent, translucent or opaque assets, and you need to be able to control and manage risk. You don't completely eliminate risk. You have

to look at risk reward. You have to price risk properly and balance it properly in order for a financial institution to be successful. And unfortunately this is what credits. Yeah, David, we don't care what we want to know Aaron Rodgers. I mean, he's got a left tackle back. The gentleman from Colorado and Boulder, David bak tr tell me all the importance of the line for Aaron Rodgers and that left tackle well back, of course, it is critical. He's

probably one of the best tackles in the league. And if you give more, if you get more time to Aaron Rodgers, you know, that's like given a sharpshooter. You know, you you he becomes even dead later. He becomes even dead later. Thank you, John, I misspelled Aaron Rodgers. I'm gonna go so much to the Packers time out chair. I'm never gonna be invited in Wisconsin again, David, thank you, thank you. How I associate it's given how cold some of those games out? Is that good enough chanting for you?

Minus thirty one degrees? Win? Chill give me a bright right now, Brent shooting gets the started here. We've got a really eventful hour for you on radio and television with Northwestern Mutual. Where short term is five years, Brent, forget about short term is five years. Let's bring it in big time to a three year perspective. What is the three year perspective? Given the cacophony right now? I think in the narrow term, I actually think the market

has legs to go higher. Now. I know we're going through this painful kind of rotation, which has always been a question of ours. Can you actually deflate some of the more excessive parts of the markets without causing that to leak into the broader market. And so far, despite all that commentary, you have seen value stocks hold up well.

You've seen hopes, dreams, themes and memes, some of those things that didn't make sense that we're bit up on excessive monetary policy, dy've deflated more than fift I think you continue to see that throughout the year. I think hopefully we get better news on COVID. I think inflation does pull back as we shift more from goods buying to services buying. And then I think that allows the Fed to be just a bit less aggressive than market is pricing against an economic backdrop that is still strong.

And I think the first half is a pretty good part of the year policy right now, Brent, And just to jump in because this is important. You think this is a problem for pockets of the market, not the overall market, at least in the front half. Yeah, And that was mentioned by Tom in the opening when you talked about a nuanced market. I mean you're seeing parts of the market that are actually doing okay. The last few weeks, you've seen value stocks hold up quite well. Look,

you've had an abnormal economy. The word economic adaptation has occurred. We had that forecast for a while that has led to market abnormalities. Hope streams, themes and memes are one, but then you also have growth strack talks trading at record pees relative to value stocks. You have large caps

trading at record pease relative to small caps. And so we think that as the economy normalizes, which we think we're continuing to do, the market will have to normalize, and that means that part of the market that hasn't done as well, that is quite frankly cheap, will do better as real interest rates move higher. Tait me to the second half, then I worry more than because at the second half of the year, we could be out

of economic slack or moving towards that. Think about it this way, at the end of two thousand nineteen we had a pretty tight labor market. Between now and the end of the year, we could be back to where we were in two thousand nineteen at the end of at the end of that time period, a later economic cycle market where we're out of labor market slack, and

then the question because becomes can productivity keep up? We only have around four million more people to hire before we're back all us being equal to where we were in two thousand nineteen, and at two hundred four hundred thousand per month, that means ten to twenty months before the labor market could potentially be tight, and that's when you might have more real inflation, not the one that you're having right now, which is based upon COVID and

some of those abnormalities. Brent, you talk about the first half and the second half and a bifurcated nature between the two halves, and you're not alone. A lot of people have said the same thing. How do you arrange a strategy where you have the flexibility to rejigger at a time when everybody is doing the same thing in response to the same inputs, and liquidity is being drained

from the system. Yeah. I mean we've been to overweight more of the value of the small, the cheaper parts of the market for some time, and we're going to continue to be overweight those parts of the market, probably to the middle half of the year. And then we start looking and thinking about do we want to bring our equity ratio down just a bit to reflect the fact that a lot of the easy money has been made. The labor market maybe tight then uh, and the output gap,

which is an important concept, maybe closed. Um. I still think the economy has legs into because I do think productivity is kind of the unsung story that will become kind of the more sung story towards the second half of the year, and that keeps us going four. But certainly the risk arising. Brent, you said that you reduced equity exposure and then go into what our bonds the place to go? Do you go into bitcoin? Uh? No, not bitcoin, I said, hope streams themes and memes, and

I would extend that to crypto. Um, just as a kind of a framework. Um. You know, that's a good question, and I guess we'll we'll cross that regimen get there. I think you're gonna see yields normalize a bit more in the coming months, which could provide the more of an opportunity in the bond market for a real return at some point. But for right now, we are still overweight equities relative to fixed income, and we'll play that day by day, Brent. Brent, final question, Can I call

negative nine celsius cold? Is that cold enough for you? It's cold enough for me, and it's cold enough here in Milwaukee, although I'm setting in my basement so it's rather warmed down here. But I think the temperatures were outrun zero outside zero fahrenheit, zero fahrenheit. That's all I do math fahrenheit French of Northwestern Uture. I'm just not familiar with fahrenheit on I asked Brent, Tom because every time I say it's freezing, you tell me this is nothing. Today.

We're on you know, we're not on the edge of Buffalo today in the negative nights. But you know, Renicent is gonna walk off the stage here if we don't get to her. A Reticent joins us right now Directive Research in Energy Aspects, and she is wonderful on the micro economics that gets you to twenty dollars a barrel and Brent crude or maybe sixty dollars a barrel and Brent crude, and we're gonna send me. There's never been a greater time out of the g d P marked

down by Golden Sex and China. The mystery of oil demand to me right now off the chart, do you have a clue what oil demand is going to be this year? Yeah, we think it is going to continue to rise and rise by about close to three million barrels per day. It's not going to be quite there, but close to that. China actually isn't going to be the biggest driver of growth because you know, you've obviously

still got zero COVID policy there. We don't necessarily think they're going to lift that anytime soon, but it is going to be the rest of Asia. Most of Asia hasn't actually had much of summer driving season, as we've seen in the West last year. A lot of parts of Asia was still in lockdown or at least under some form of mobility striction. So you're going to see you are already seeing a lot of strong demand growth

numbers coming out of there. Of course, now cases are rising everywhere in the East, but once we are through this period, the summer should be very, very strong and reading what do you make of this Francisco Blanche of Banco America call for a hundred dollars or plus oil prices by the second quarter. I mean our price forecast, which has been, like you know, consistent for a few years now, we've been calling for a hundred and fourteen dollars for next year. That's an annual average. Of course,

it goes well above one next year. We don't necessarily see that this year, even though we are saying and our models are showing that that inventories globally are not just at a record low levels um this summer, they're going to fall down to those levels, but they are going to be at levels we've really never seen, specially on a global basis, but especially in in a non O E c D countries. So yes, there are risks that prices go higher. I mean, our annual average for

this year is eighty five. But the worry of us in the near terms still is COVID demand is still hamstrung. OPEC still has barrels to give, so for us, the real spike in oil price story remains second half, like really end of this year into next year. The caveat to that is these supply outages. We've seen so many of them Ecuador, Libya, Nigeria, Kazakhs down recently. If these keep mounting, of course you can get two hundred dollars earlier, but without those it will still be end of the

year into next year. How much are we underestimating the higher cost to actually refine some of the oil that's going to be coming online, especially in light of some of the other material inflation that we've seen around the world. It's a great question, and you know, something we've been accounting for in our balances. To to Tom's point, in terms of the economics of it, it becomes very important.

We are looking at cost inflation of at least ten to fifteen percent across the upstream industry, and that just means that again, you need a higher price just for these producers to bring even because they need that much more in terms of their equipment and just for sustaining

their production. So that's a minimum tend toftcent. In some areas we're hearing about inflation when it comes to oil services and said, just finally, how strong is our understanding of the relationship between say, banant sheet reduction and creed prices, interest rate hikes and create prices. The latter We have

a ton of experience with the form and us so much. Oh. Absolutely, And I think this is going to be again if you talk about wild cards or you know, just events outside of the core fundamentals of oil impacting crew this year, it's going to be hugely important. Um generally speaking, if we do enter a period of tightening monetary policy or even physical policy for that matter, we are going to be in a period of lower growth and by definition

lower oil prices. But if you that is accompanied with inflation, oil tends to do perform very well in a high inflationary period. So that's your juxtap position with that theory, This is really tough. That's the bottom line. I'm ready to sent Thank you of Energy Aspects. This is the

Bloomberg Surveillance Podcast. Thanks for listening. Join us live weekdays from seven to ten am Eastern on Bloomberg Radio and on Bloomberg Television each day from six to nine am for insight from the best in economics, finance, investment and international relations. And subscribe to the Surveillance podcast on Apple podcast, SoundCloud, Bloomberg dot com, and of course, on the terminal. I'm Tom Keene, and this is Bloomberg.