Fed's Mishkin: Core inflation focus best for economy

By Gene Cherry

GREENVILLE, North Carolina (Reuters) - Federal Reserve Governor Frederic Mishkin on Monday defended the central bank's emphasis on core inflation, saying an emphasis on less volatile prices produces a stronger economy in the long run.

"Stabilizing core inflation ... leads to better economic outcomes than stabilizing headline inflation," Mishkin said in a speech at East Carolina University.

Core inflation strips out volatile food and energy costs.

Meanwhile, Mishkin's colleague, Fed Governor Randall Kroszner, acknowledged that currently elevated inflation levels put policy-makers in a delicate spot.

"We have seen some (inflation) numbers in recent reports that are higher than we had seen before," Fed Governor Randall Kroszner said in answer to a question as he addressed a group of financial institution risk managers in New York.

"We have to be very, very mindful of our dual mandate ... and trying to get the balance right can be a challenge," he said, referring to the Fed's twin goals of promoting job growth and keeping price increases in check. He added that the Fed was looking at both issues "extremely carefully."

The Fed generally lowers interest rates to boost growth but raises borrowing costs to keep inflation in check.

ANCHORED EXPECTATIONS

The Fed has cut interest rates aggressively to counter a deep housing slump and a credit crunch linked to worries about delinquent mortgage payments. The Fed's benchmark fed funds rate stands at 3 percent, down from 5.25 percent in September, and the central bank is widely expected to cut short-term U.S. interest rates again at its March 18 meeting.

In the meantime, inflation has climbed on the back of record oil and commodity prices, pushing the Consumer Price Index up 4.3 percent in the 12 months through January.

Fed Chairman Ben Bernanke is expected to shed more light on the Fed's concerns about economic growth and inflation in his semi-annual testimony before congressional committees on Wednesday and Thursday. The central bank said last week it expects inflation to moderate as the economy grows at a slower level than its full potential.

Mishkin said on Monday that the central bank must avoid reacting to swings in overall inflation produced by energy price shocks, saying an emphasis on less volatile prices produces a stronger economy.

Without directly nodding to current inflation data, Mishkin said that if central banks raise rates aggressively to counter inflation caused by a sudden rise in oil prices, unemployment will be "markedly higher" than if policy-makers set borrowing costs in response to fluctuations in core prices.

He added that any rate increases aimed at squelching inflation produced by energy price spikes would have to quickly be unwound once prices drop.

The shock of energy price increases is likely to have only a temporary impact on inflation because inflation expectations are contained, Mishkin said.