Fed eyes inflation target as deflation fears rise

By Ros Krasny - Analysis

CHICAGO (Reuters) - Inflation targeting is back on the Federal Reserve's radar and could become part of a "no holds barred" policy approach at a time the bank's ability to pull the U.S. economy out of recession and quash deflation risks is hampered with interest rates already near zero.

The focus on unorthodox policy measures at the Fed -- the U.S. central bank -- so far has been on several programs designed to pump money into credit markets as a substitute for cutting interest rates, which they can't move lower.

But minutes from the December 15-16 meeting of the Fed's monetary policy-setting Federal Open Market Committee released on Tuesday and remarks from some key policy-makers suggest communications strategies are up for a fine-tuning too.

In particular, a proposal to implement a formal target level or range for desired inflation seems to have been dusted off.

"Added clarity" on the preferred rate of inflation "might help forestall the development of expectations that inflation would decline below desired levels," the minutes said.

The cost of oil and other commodities has crashed as global demand has slumped, and a report showing the United States lost 524,000 jobs last month -- bringing losses for 2008 to a whopping 2.6 million -- underscored the depth of the recession that has fostered incipient fears of deflation, a damaging spiral of falling prices causing economic contraction as consumers hold off buying in the hopes of yet lower prices.

San Francisco Fed President Janet Yellen, an FOMC voter this year, said on Sunday that chances are high that inflation will fall too low for comfort over the next few years.

"With growing economic slack, inflation may well decline, for a time, below levels that best promote the dual goals of full employment and price stability," Yellen said.

With interest rates at the zero bound, "any downdrift in inflation expectations leads to an updrift in real interest rates" that can further sap the economy, she said.

The Fed has taken what Yellen called "incremental steps" toward making its longer-term inflation goals more explicit, but a number of officials believe a target could tamp down the risk markets and the public could come to expect a declining price level in a way that could become self-fulfilling.

"There could be scope for the committee to improve the clarity of these communications," Yellen said in comments some Fed watchers interpreted as one of the strongest hints yet policy-makers were leaning toward adopting a target.

St. Louis Fed President James Bullard was even more blunt on Saturday: "Now would be a particularly good time (for an explicit target) because you have this possibility of expectations drifting off to deflation or a lot of inflation."

NO MORE COMPROMISE?

The Fed's congressionally set dual mandate, which requires it to pursue both low inflation and full employment, in the past was seen as an impediment to targeting to help keep inflation at bay. Many central banks that use targets have only a single, low-inflation mandate.

Now, however, the risk of a widespread decline in prices is conversely seen as an argument in support of a target to help keep inflation from falling too far.