Is the Fed ready to consider lifting its inflation target?

By Howard Schneider

WASHINGTON (Reuters) - Years of tepid economic recovery have Fed Chair Janet Yellen and other central bankers considering what was once unthinkable: abandoning decades-long efforts to hold inflation down and allowing price expectations to creep up.

In remarks on Wednesday, Yellen called an emerging debate over raising global inflation targets "one of the most important questions facing monetary policy," as central bankers grapple with an economic rut in which low growth, low interest rates and weak price and wage increases reinforce each other.

The aim would be a change of households' and businesses' psychology, convincing them that prices would rise fast enough in the future that they would be better off borrowing and spending more today.

 

Success in anchoring inflation in the 1980s and 1990s defined central banking throughout the developed world.

It has become a core aim of the Fed and an article of faith for Germany's Bundesbank and later the European Central Bank, founded in 1998 with the mandate of maintaining price stability defined as inflation under 2 percent.

That 2 percent target, which translates into prices doubling roughly every 35 years and is considered both offering stability and a sufficient buffer from deflation, is now common for the developed world's central banks.

Raising that target to 3 or even 4 percent as some economists have suggested would shift the outlook of firms in particular, allowing them to charge more for goods and pay more for labour without the fear that a central bank would step on the brakes.

To be effective, the Fed would have to back that new target with a slower pace of any rate increases than it would otherwise deem appropriate.

That could prove risky for the central bank that has repeatedly missed its present target and conditioned people to expect subdued price and wage increases, said Moody's Analytics analyst Ryan Sweet.

"The Fed would have to clearly and convincingly communicate the rationale for raising the inflation target and the potential economic benefits. Otherwise the central bank will lose in the court of public opinion."

In a sense, the Fed may be a victim of its own success and Yellen in the past has been sceptical the Fed could change expectations that were anchored by its ability to keep actual inflation low for years by simply raising its goal.

"It's a paradox," said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics. "There is less response of inflation when the Fed is successful."

By allowing inflation to run higher, the Fed would create more room for nominal interest rates to rise later without crimping economic growth, advocates say. With rates expected to remain historically low, Yellen and her peers are worried that even a mild recession will force them to cut interest rates to zero and deploy crisis-era tools, such as asset purchases, something they could avoid if rates in general were higher. Sceptics, however, question whether lifting the inflation target would have any lasting effect on economic activity.

TO LIFT OR NOT TO LIFT

During the current eight-year recovery the Fed has steadily marked down its estimates of U.S. economic potential, the interest rate needed to achieve it, and generally failed to get inflation back to 2 percent. Yellen on Wednesday said it may be time for a rethink.

"We've learned a lot," Yellen said about the time since 2012 when the Fed set the inflation target. One conclusion was that interest rates will be stuck at historically low levels unless something changes. Whether to raise the inflation target hoping it could be a catalyst of change "is one of our most critical decisions," she said in what was the clearest indication of a debate taking shape inside the Fed.

Central bankers in Europe, Japan, Britain and elsewhere have begun exploring the option as well, while the Bank of Canada reviews its inflation target every five years

Any move is unlikely in the near term.

Policymakers may not like missing their targets, but they also recognise the benefits of only modest price increases brought by central bank policies and a globalising world economy that helped drive manufacturing costs down.

Since the early 1990s median U.S. household income and overall consumer inflation have marched in virtual lock step. Health care and education cost have grown faster, but prices for clothes, furnishings and food have generally increased less or no more than household incomes - benefiting the poor who suffered the most during bouts of high inflation. (Graphic: http://tmsnrt.rs/2t6NKld)

But that may also have created a "sticky" psychology.

Modern monetary policy rests heavily on a central bank's ability to shape expectations, and the Fed and others have been so successful in keeping inflation down that now they seem unable to shift sentiment in the opposite direction.

The Fed is also no longer quite sure about how some basic aspects of the economy are working these days.

At 4.3 percent, the jobless rate is at a 15-year low, yet wage growth is weak and inflation has recently slipped further away from the Fed's goal.

Quite how far it is prepared to go will depend on what Yellen noted was an assessment of "the potential costs that could be associated" with a higher inflation target. Such assessment, however, probably will not be ready during her term, which ends in February 2018.

(Reporting by Howard Schneider; Editing by David Chance and Tomasz Janowski)