As she heads toward retirement at the end of the month, Federal Reserve Bank of Cleveland President Loretta Mester still believes the central bank needs to remain open to active sales of mortgage bonds as part of its ongoing efforts to reduce the size of its balance sheet.
While any such action is not “imminent,” Mester noted that the Fed’s existing goal to get back to holding only Treasury bonds means it may have to take active measures to shed mortgage bonds, or MBS, bought as part of the effort to restore market function and stimulate the economy in the wake of the onset of the coronavirus pandemic.
“At some point I would be open to selling, for the [Federal Open Market] Committee to sell MBS,” Mester said in an interview with Reuters. “I don’t think it’s immediate that we should be selling MBS,” Mester said. “I think eventually we may want to” and would need to educate the public on why that might happen, especially since there may be losses for the Fed on some of those bonds.
Mester spoke on the outlook for the Fed’s balance sheet as the central bank crossed the two-year mark of allowing its holdings of Treasury and mortgage bonds to contract passively. The Fed has since June 2022 been allowing a portion of its bonds to mature and not be replaced, taking holdings from a peak of $9 trillion to the current level of $7.3 trillion.
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Most of the drawdown is attributable to the runoff of Treasury bonds owned by the Fed. The central bank has faced a much tougher time unloading mortgage securities due to a much-slowed home housing market that’s lowered refinancing and purchasing activity, meaning mortgage bonds are taking longer to mature.
The Fed expressly aims for an all-Treasury balance sheet but if current trends persist it may be impossible to get there without turning to active sales. But in two episodes of quantitative tightening, or QT, the Fed has never actively sold bonds, and it’s unclear how markets might react.
Mester’s ongoing openness to mortgage bond sales comes as she is set to retire at the end of the month after a career at the Fed, with the last decade helming the Cleveland Fed.
Mester exits amid an expectation that inflation will cool over time and eventually allow the Fed to cut rates.
If the economy performs as expected, “then it is reasonable to have policy begin to move back the interest rate, the Fed funds rate, back to a more normal level,” Mester said. “I’d like to see a few more months of data” before gaining confidence easier policy is warranted, she said, noting monetary policy is in a good place to deal with how the economy might perform.
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MARKET MAKEOVER
Mester’s retirement also comes amid a shift in the profiles of those who lead some of the Fed’s 12 regional banks, with a rise in the number of regional bank chiefs with expertise in how markets work.
Her successor is Beth Hammack, a former top Goldman Sachs banker with extensive market experience. Earlier this year the St. Louis Fed also named a new leader with deep trading and investing experience, and the current head of the Dallas Fed, Lorie Logan, previously had a central role in monetary policy implementation at the New York Fed.
The rise of market experience at regional banks could in the view of some Fed watchers provide an unusual counterweight to the New York Fed, which acts as the Fed system’s main market agent.
The rise of these new regional Fed chiefs signals “a clear trend” by the Fed “to prioritize the concentration and diversification of financial market experience directly at the highest level of the [Federal Open Market Committee,]” said analysts at advisory firm LHMeyer.
“Having more market expertise has to be useful, when the Fed is dominated by Ph.D economists,” said William Dudley, who led the New York Fed from 2009 to his retirement in 2018. “One value of a markets background is that it teaches you to question what is the conventional wisdom.”
“I, for one, think that is a useful orientation if you want to look a bit better around the corners,” he said.
Speaking to reporters at the end of May, New York Fed President John Williams was also upbeat about the shift, saying the central bank’s greater involvement in markets by way of balance sheet policies changes what leaders need to know. “Getting kind of a really good understanding of not only economic conditions but conditions in financial markets is really important.”
Mester, who was not involved in the process of selecting a new bank president, said from her perspective “different backgrounds are very important” for the Fed.
By way of her own legacy, Mester said she was particularly proud of the work her bank had done on studying inflation, including establishing the Cleveland Fed’s Center for Inflation Research.
Mester said that has been a long-standing specialty of the Cleveland Fed, adding the center has been “contributing a lot, not just to our bank, but to the public as well, so they understand inflation a bit more than they did, and to the whole FOMC because we’re all using that research.”
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