Fed Officials Mull Inflation as a Fix for US Economy

By SUDEEP REDDY - OCTOBER 7, 2010 - WSJ

The Federal Reserve spent the past three decades getting inflation low and keeping it there. But as the U.S. economy struggles and flirts with the prospect of deflation, some central bank officials are publicly broaching a controversial idea: lifting inflation above the Fed's informal target.

The rationale is that getting inflation up even temporarily would push "real" interest rates—nominal rates minus inflation—down, encouraging consumers and businesses to save less and to spend or invest more.

Both inside and outside the Fed, though, such an approach is controversial. It could undermine the anti-inflation credibility the Fed won three decades ago by raising interest rates to double-digits to beat back late-1970s price surges. "It's a big mistake," said Allan Meltzer of Carnegie Mellon University, a central bank historian. "Higher inflation is not going to solve our problem. Any gain from that experience would be temporary," adding that the economy would suffer later.

Others warn that pushing inflation higher than the target could create public confusion and risk fueling financial bubbles and market instability. They say Fed policy already is weakening the dollar and as a result prompting a gold and commodity boom. "The Fed is treading upon a mine-laden path that has never been tip-toed through in this country," said Andrew Busch, a currency strategist at BMO Capital Markets.

With the Fed's target for short-term rates already near zero, inflation too low—floating between 1% and 1.5%, below Fed officials' informal target of between 1.5% to 2%—and unemployment, at 9.6%, too high, Fed officials are expected to embark on a new round of asset purchases to lower long-term interest rates.

In the past week, two Fed officials raised the option of explicitly pursuing above-target inflation for a time to offset periods in which inflation is below target. New York Fed President William Dudley suggested that if inflation were to undershoot the central bank's target by half a percentage point next year, the Fed could offset the miss with an additional half-point increase later on.

And, in an interview, Chicago Fed Charles Evans said, "It seems to me if we could somehow get lower real interest rates so that the amount of excess savings that is taking place relative to investment needs is lowered, that would be one channel for stimulating the economy."

More on Inflation

Officials outside the Fed have proposed using higher inflation to get real interest rates down. Earlier this year, International Monetary Fund chief economist Olivier Blanchard suggested that nations doubling their inflation target to 4% from 2% wouldn't be risky.

Such a move could provide more room to support the economy at a time when central banks have cut short-term interest rates nearly to zero but still face weak economies, a scenario Japan has faced since the 1990s and the U.S. is confronting now. Axel Weber, head of the Deutsche Bundesbank, and Philipp Hildebrand of the Swiss National Bank called the proposal "severely flawed."

In a speech in 2003 when he was a Fed governor, Fed Chairman Ben Bernanke suggested that Japan attack prolonged deflation by announcing its goal of restoring the price level to the level it would've reached under moderate inflation. That approach, he explained, would lead initially to a "reflationary phase of policy" to bring prices back up to what would've been expected before the deflation.

But in a speech this summer, Mr. Bernanke said that raising medium-term inflation goals would amount to a "drastic" measure that's inappropriate for the U.S. economy. "Raising the inflation objective would likely entail much greater costs than benefits," he said. Inflation would be more volatile, bring more uncertainty and possibly create destabilizing moves in commodity and currency markets that "would likely overwhelm any benefits arising from this strategy," Mr. Bernanke said.

Mr. Dudley and Mr. Evans, however, are making a slightly different argument: They would leave the informal inflation target unchanged, but overshoot it for a time to compensate for the current undershoot.

Some economists question whether the Fed has the power to push inflation higher in today's weak economy. "Inflation expectations are not just pulled out of thin air," said William Poole, former president of the Federal Reserve Bank of St. Louis. "The time when the Fed would have a good chance of hitting a higher inflation target is exactly the time when it would not make sense to do so."

Ethan Harris, head of North American economics at Bank of America Merrill Lynch, suspects Fed officials raising this possibility are, in part, trying to push their colleagues toward more stimulative policy and reassure the public and markets that they still have the capacity to keep the economy away from the shoals of deflation and renewed recession. "I think they're worried about the perception that the Fed is out of ammunition, which is a very dangerous perception for the markets and the economy," he said.