Fed mulls controversial inflation idea

President of the New York Federal Reserve Bank William Dudley in a file photo.

NEW YORK (Reuters) - The Federal Reserve is running short of tools to tackle uncomfortably low inflation, and officials are now mulling whether it might help to shoot for inflation above their informal target.

Two top Fed officials, including the influential vice chairman of the central bank's policy panel, have suggested the Fed consider making up for inflation shortfalls now by aiming for higher inflation later.

This could help return the price level to what was expected by people who signed long-term contracts before inflation slowed and could help support expectations of future inflation in a way that could battle deflation risks.

In theory, so-called price level targeting can ease financial conditions: If people expect inflation to go up in the future, the real cost of credit -- which is adjusted for inflation -- would fall.

New York Fed President William Dudley, the vice chairman of the policy-setting Federal Open Market Committee, has said that to the extent such a policy were credible it could help keep inflation expectations from falling.

"This might make monetary policy more stimulative and, thus, might help the FOMC achieve its objectives more quickly," he said on October 1.

The Fed, with a dual mandate of promoting full employment and price stability, has already cut interest rates to the bone and bought $1.7 trillion of assets to further lower borrowing costs. Markets expect the Fed to embark upon a new program of asset buying as early as its next meeting on November 2-3.

Chicago Fed President Charles Evans, in an interview with the Wall Street Journal earlier this week, said he worried asset purchases may not be enough on their own to push inflation higher and may need to be supplemented by other options.

But many experts -- including Dudley himself -- say a price-level target is difficult to communicate to the general public whose views of future inflation may be closely tied to what has happened with prices in the past.

"A price-level target is really a gamble on whether people are forward looking," said Charles Goodhart, a professor at the London School of Economics. "The problem is that most evidence suggests that most of the time people are backward looking, so it won't have an impact on inflation expectations."

There is also the risk that the targeting hurts the Fed's hard-won credibility if it fails to deliver on its promise. And it could bind the hands of future Fed policy-makers, who may not be willing to tolerate slightly higher inflation.

THEORY ONLY?

Fed Chairman Ben Bernanke appears to have some strong reservations about the tool.

Speaking in August, Bernanke said a price-level targeting strategy "is inappropriate for the United States in current circumstances" when inflation expectations and actual inflation were within ranges consistent with price stability.

The Fed has an informal inflation target of 1.7 to 2 percent. For the 12 months through August the core personal consumption expenditure price index -- the Fed's preferred inflation gauge -- was running at 1.4 percent.

"I believe the chairman would only favor this after deflation has taken hold, based on his previous comments. As of now, I think it's on the table but just as a discussion point," said Michael Gapen, director of U.S. economics research at Barclays Capital and a former Fed staffer.

The communications challenge is also something that has so far kept the Bank of Canada -- which has an inflation target of 2 percent -- from implementing a price-level target, even though it has been studying it as an option since 2006.

Another concern is that the approach would necessarily be asymmetrical. When inflation was running above target, officials may be hesitant to intentionally push it below target out of fear of creating a deflation risk.

In his August speech, Bernanke warned that price-level targeting could make inflation more volatile, adding that "the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy."

But Mark Gertler, a professor at New York University, said with the outlook for inflation and unemployment dire and options limited, U.S. policy-makers might be more open to this approach.

"You'd have to communicate you're not talking about significant overshooting, just mild overshooting" of the current informal target, Gertler said. "I think in this environment it could make some sense."

Of course, just discussing the option could signal to the markets that the Fed is willing to do more to avert a dangerous downward price spiral.

Jeff Fuhrer, director of research at the Federal Reserve Bank of Boston, said uncertainty is high about the effectiveness of any the Fed's current options.

"As a consequence, I could imagine trying several in combination," he said. "If any or all have effects, I'd be delighted."

(Editing by Padraic Cassidy)