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Federal Reserve flirting with higher inflation

A view shows the Federal Reserve building on the day it is scheduled to release minutes of the Federal Open Market Committee from August 1,
A view shows the Federal Reserve building on the day it is scheduled to release minutes of the Federal Open Market Committee from August 1,

By Jonathan Spicer and Ann Saphir

NEW YORK/SAN FRANCISCO (Reuters) - Will the U.S. Federal Reserve look the other way if inflation overruns its target?

Risking the wrath of politicians and the central bank's hard-won reputation for keeping prices stable, three top Fed officials are touting plans for boosting employment that explicitly allow for inflation to run above the Fed's 2.0-percent goal.

Investors are wondering just how high - and for how long - the Fed may allow inflation to rise to encourage borrowing, investment and hiring. In theory, more people working means higher output, which should narrow the gap between what American workers are currently producing and their potential.

"The Fed's body language clearly says they think the output gap is huge and that they're willing to take risks on inflation," said Bluford Putnam, chief economist at futures exchange operator CME Group.

The Fed reduced official interest rates to near zero almost four years ago and has since then bought some $2.3 trillion in securities to boost the economy, taking the central bank deeper into uncharted policy territory.

With the U.S. economy still recovering only slowly, last month the Fed said it would keep buying bonds until the labor market outlook improves "substantially," a move that many investors expect will boost inflation, currently running below the 2.0 percent target.

Since the announcement, the central bank's top policymakers have been busy drawing their lines in the sand.

Minneapolis Fed President Narayana Kocherlakota says he would tolerate inflation of 2.25 percent, and John Williams of the San Francisco Fed says he's OK with 2.5 percent. The Chicago Fed's Charles Evans, considered one of the central bank's most pro-growth "doves," says he'd hold fast to low rates as long as the outlook for inflation stayed below 3 percent.

Volatility in bond markets suggests investors are adjusting their bets as to the true intentions of Fed Chairman Ben Bernanke and his core of policymakers, and whether they will be able to control inflation when the time comes.

"I wouldn't be surprised if they let it run to 3.0 percent for a quarter or two and still rationalize that by saying they still haven't seen unemployment go down like they want it to," said Mike Knebel, portfolio manager specializing in fixed income at Ferguson Wellman Capital Management in Portland, Oregon.

"Three percent still seems to be a fairly reasonable number in most people's minds - at least those of us who are old enough to remember when six percent was considered the norm," he said.

BERNANKE'S QUIET VICTORY

Inflation soared to over 14 percent in 1980 before the Fed under then-Chairman Paul Volcker finally wrestled it back down. Albeit far less severe, the last time inflation fears gripped the United States was in 2008, just before Lehman Brothers collapsed at the height of the financial crisis.

While inflation targeting has been a bedrock of central banking internationally for decades, the Fed only this year adopted an explicit target inflation but also, unlike most of its peers, is charged not only with keeping prices stable but also with maximizing employment.

In August, the Fed's preferred annual measure of inflation, the Commerce Deptartment's personal consumption price index was up just 1.5 percent for the year in August, while the more broadly watched U.S. Labor Department's consumer price index increased 1.7 percent. September's reading of the consumer price index is to be published on Tuesday and is forecast to see inflation at 1.9 percent.

Prices have generally stayed low and stable the last three years, representing a quiet victory for Bernanke amid fallout from the brutal recession in 2008 that threatened a period of deflation, which is the phenomenon of falling prices that held Japan in a slump for a decade.

After the central bank made its bold statement last month, announcing further bond buying until unemployment falls significantly, Bernanke was at pains to say that getting more Americans back to work would not come at the cost of higher inflation.

If inflation were to run above target, he told reporters, the Fed will bring it back to 2.0 percent "over time" as part of a balanced approach to achieving its two mandates of price stability and full employment.

One key indicator of inflation expectations, based on the gap between regular and inflation-protected U.S. Treasury bonds, jumped to a six-year high of 2.65 percent after the Fed's decision on September 13.

That so-called "breakeven" rate, which tracks expectations for inflation 10 years from now, is currently running at about 2.47 percent, according to Reuters data.

WILLIAMS NOT BUYING

Most people see inflation as a bad thing. Higher wages mean more money in consumers' pockets, but the price of everything they want to buy rises as well, typically too quickly for earnings to keep up.

Left to rise too fast for too long, inflation also risks devaluing the currency and stanching economic growth. The fact that gold prices, which usually move opposite the U.S. dollar, remain near record highs reflects concerns about future inflation.

But many influential economists believe that higher inflation expectations translate into lower "real," or inflation-adjusted, interest rates, which could stimulate the economy, an attractive selling point for a central bank running out of policy options.

Not everyone is buying the idea, including Williams, the policy-centrist chief of the San Francisco Fed, who this week announced that inflation would need to rise to 2.5 percent before he would want to rethink the Fed's low-rate policy to boost jobs.

"You would expect inflation to fluctuate within some kind of reasonable band, so say between 1.5 percent and 2.5 percent. Even in normal situations, inflation tends to fluctuate because of various shocks and events," Williams told Reuters on Wednesday.

But acknowledging that he is not troubled by inflation of up to 2.5 percent is a far cry from purposely stoking it to bring down real interest rates, or to cut the burden of household debt, he said. Firstly, he said, the Fed does not have that kind of hair-trigger control.

"The idea that you could create 4.0 percent inflation for a few years, and then bring it back to 2.0 percent, is a dream, a false dream," Williams said in his office overlooking San Francisco Bay.

The risk of trying that approach and then failing, he said, is a costly recession, the likes of which the United States has not seen since the Fed ratcheted up interest rates by about 16 percentage points to battle raging inflation through the 1970s and early 1980s.

But even if such precise managing of inflation were possible, higher inflation expectations may not generate the benefits that modern macroeconomic theory tends to predict, Williams noted. Instead of pushing up wages and house prices and trimming the real value of household debt burdens, higher inflation might simply create greater uncertainty, curbing investment and growth, he said.

Inflation could also damage the Fed's credibility, which many cite for U.S. price stability in the first place.

TRADING THE INFLATION TARGET

Supporters of more easing say the Fed has no intention of turning a blind eye to inflation.

"I disagree with the premise that what we're doing is seeking to gin up inflation," Jeremy Stein, the Fed's newest governor and a strong backer of the Fed's recent policy easing, said on Thursday.

Intentional or not, markets appear to believe that the Fed's inflation stance has shifted, if only slightly.

The brief jump in breakeven rates suggested investors are repricing the exact meaning of the central bank's inflation target, which may be warranted "if the Fed's policy stance implies a potentially somewhat higher inflation rate in coming years," said Roberto Perli, managing director of policy research at broker dealer International Strategy and Investment Group.

Charles Plosser, the head of the Philadelphia Fed and an inflation hawk who opposed the recent round of easing, warned, however, that the central bank may be sending the wrong signals.

Some people have interpreted the Fed's statement last month, that it won't start raising interest rates as soon as a U.S. economic recovery strengthens, to mean it is willing to tolerate higher inflation in order to lower the unemployment rate, Plosser said on Thursday.

"This is another risk," he said, "to the hard-won credibility the institution has built up over many years, which, if lost, will undermine economic stability."

(Reporting by Jonathan Spicer and Ann Saphir; Additional reporting by Chris Reese; Editing by Dan Grebler)

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