Fed's Mester: 'Gradual' rate hikes to continue

Loretta Mester, president of the Cleveland Federal Reserve.
David Orrell | CNBC

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Volatility in financial markets as well as deflationary pressures from the plunge in energy prices shouldn't keep the U.S. central bank from raising rates, Cleveland Fed President Loretta Mester said Thursday.

Echoing themes expressed by her colleagues recently, Mester said she still sees the long-run path of inflation meeting the the Fed's goals. That's despite a harrowing bear market in oil that has caused spillover damage into the stock and bond markets as well as corporate earnings.

The Fed at its December meeting hiked its interest rate target a quarter point but declined to act again in January. Mester said she agreed with both decisions.

However, she said market participants still should expect the Fed to continue on a tightening path, albeit a slow one.

"While the actual path the fed funds rate follows will depend on the economic outlook, and thus, will be data dependent, my current view is that economic conditions will evolve in a way that will warrant rates moving up gradually over time to more normal levels," Mester said, according to prepared remarks marks she was to deliver to a Market News International gathering in New York.

She acknowledged the decline in energy prices and net exports among other weakness in the economy. However, she also noted "solid labor market indicators, including strong payroll growth and healthy growth in real disposable income" that "suggest at underlying U.S. economic fundamentals remain sound."

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Mester also said she would like the Fed to begin winding down its $4.5 trillion balance sheet, which ballooned during the three rounds of quantitative easing used to boost market liquidity and spur economic growth. That likely won't happen, though, until the Fed is able to push the funds rate to about 1 percent.

"There's no real science about 1 percent," she said. "Once we get away from zero on the funds rate, it makes sense to move."

Mester generally has been one of the more hawkish members of a Fed that has been remarkably dovish since 2008. The central bank kept its funds rate near zero for seven years and had not hiked since 2006.

But with the labor market trending toward full employment and worries growing over excessive risk taking, the Fed has been trying to normalize. The December hike was met with a sharp round of volatility, and market projections for the future path of rate hikes have diminished significantly.

Despite her expectations for continued increases, Mester emphasized the pace will be "gradual" and conceded that the so-called dot plot of Fed rate projections is not etched in stone.

She said the projections in December that indicated four rate hikes this year "are not a commitment because in order to best achieve our goals of maximum employment and price stability, policy should be expected to react in a systematic fashion to material changes in the outlook."

"If the economy's evolution turns out to be different from what we currently anticipate, our policy path may well have to deviate from what our current expectation is," she said.