UPDATE 4-Central bankers cool to IMF's inflation idea

Wed Feb 24, 2010 2:34pm EST

Related Topics

* Fed Chairman Bernanke wary of higher inflation target

* Bini Smaghi: Hiking target would be "diabolical" error

* ECB's Weber says hiking target would open Pandora's box

* Wrong to think stimulus alone can revive global economy (Adds Bernanke)

By Francesca Landini

PAVIA, Italy, Feb 24 (Reuters) - Raising inflation targets as part of the monetary policy pursued by central banks would be a "diabolical" error, European Central Bank Executive Board member Lorenzo Bini Smaghi said on Wednesday.

U.S. Federal Reserve Chairman Ben Bernanke said the idea of aiming for a higher inflation target, spelled out in an International Monetary Fund research paper, made some sense, but he worried it would be tricky to control.

"I understand the argument, and it's not without its appeal, but it carries certain risks, obviously," Bernanke said in testimony before a congressional committee. "If the Federal Reserve says we're going to raise inflation to 4 percent, how do we know that later it won't go to 5 or 6 or 7?"

Axel Weber, who heads the German Bundesbank and sits with Bini Smaghi on the ECB's rate-setting Governing Council, said the proposal was playing with fire.

In a speech at the University of Pavia in Italy, Bini Smaghi said it was wrong to think the global economy could exit the financial crisis and return to sustainable growth simply through stimulus measures.

Instead, policy-makers need to throw out the solutions of the past and rethink their whole approach, taking into account that markets do not always price assets in an efficient way and assuming lower economic growth than in the past.

A DANGEROUS IDEA

Some economists who still believed in the power of monetary and fiscal policy had even suggested that central banks should aim for higher inflation rates to create more room to move with rate cuts when crises hit.

"It's as if to say that the main problem with monetary policy in the recent past was that the so-called Greenspan put had not been potent enough to avoid the negative consequences of the bursting of the bubble, rather than being a mistaken policy which fuelled the bubble in the first place," Bini Smaghi said, referring to easy policy under former U.S. Federal Reserve Chairman Alan Greenspan.

"The suggestion to raise the inflation target is diabolical," Bini Smaghi told journalists after the speech.

IMF economists said in a research paper this month that policy-makers might consider raising the 2 percent inflation target chosen by many central banks to 4 percent. [ID:nN12186196]

The study is a dangerous proposal, Axel Weber said, in comments which chimed with Bini Smaghi.

"The IMF is playing with fire," Weber wrote in a guest column in the German daily Financial Times Deutschland, to be published on Thursday, but made available to news agencies on Wednesday.

Higher inflation would harm more than benefit, he said, and added the proposal risked endangering the credibility of central banks as guardians of price stability and could open a Pandora's box.

The ECB aims to keep inflation below but close to 2 percent, and in the past, it has resisted suggestions that it change its price stability goal.

For U.S. Federal Reserve officials, the risk that inflation expectations might drift outside their presumed comfort zone of around 2 percent is particularly worrisome now.

The U.S. economy went through a bout of high inflation in 2008, when oil prices soared to record highs, followed by a deflation scare in 2009 when the recession intensified.

Bini Smaghi also played down the risk of other countries catching the Greek disease, saying there is no risk of contagion as long as Athens carries out measures it has promised.

WASTE OF TIME

Bini Smaghi also said the euro zone needs low interest rates for now, but the ECB cannot commit to keeping them low in the future and will base its decisions on economic conditions.

He said policies pursued before the crisis were aimed at maintaining excessive rates of economic growth and developed economies had not realized globalisation could bring slow growth, a lower standard of living and more inequality.

"If the above hypothesis is correct, then it's a mistake to think that we can get out of this crisis and back on a path of sustainable growth only through the support of fiscal and monetary policies," he said.

"It would be an illusion ... and a waste of time and effort."

If policy-makers wanted to return economies to a path of prosperity, they had to fundamentally reform the way economies worked and competed in the global environment, he said, suggesting the works of economists such as John Maynard Keynes and Paul Samuelson as good reading material.

For a copy of the speech text, please see: here (Additional reporting by Emily Kaiser in Washington; Writing by Deepa Babington and Krista Hughes; Editing by Ron Askew and Jan Paschal)

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