* U.S. policymakers drawing their lines in the sand
* Investors mull the meaning of Fed’s 2.0-percent target
By Jonathan Spicer and Ann Saphir
NEW YORK/SAN FRANCISCO, Oct 14 (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 Sept. 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.”
