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Playing house with inflation

LONDON (Reuters) - Flirting with inflation may well raise the chances of getting married to it, but a period of temporary co-habitation may be more likely and -- some say -- even desirable.

Last month’s provocative paper by International Monetary Fund chief economist Olivier Blanchard, suggesting higher inflation targets for the world’s major central banks, met with a predictably swift and stinging response from European monetary policymakers in particular.

Bundesbank chief and arch inflation hawk Axel Weber led the retort in a series of newspaper articles and speeches that sharply criticized Blanchard for even raising the issue -- so dangerous did he see the idea to public inflation expectations.

“Flirting with inflation is quite a dangerous thing -- you might end up being married to it,” said Weber, tipped by many to succeed Jean-Claude Trichet as head of the European Central Bank next year. His ECB colleague Lorenzo Bini Smaghi went one step further and described the thinking as “diabolical.”

The ECB response is hardly surprising -- at least not for central bankers wedded for decades to money supply targets, if not strict inflation ones, and mindful of the historical context and consequences of German hyperinflation of the 1920s.

In essence, they see inflation as taxing the meager spending and fixed incomes of the old and the poor and fomenting social instability in the process. And by seeding expectations, history shows high inflation takes many years to drag back down.

Even U.S. Federal Reserve Chairman Ben Bernanke said in his own, notably milder, put-down of Blanchard’s trial balloon: “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?”

Many private economists agree with the indignant central bankers.

Blanchard’s central case -- that inflation targets, and hence interest rates, may have been too low to cope with shocks like the credit crisis because nominal rates cannot go below zero -- has been criticized for overestimating the sensitivity of consumption and borrowing to interest rates alone.

Japan, and more recently Britain, illustrate the risks of these so-called liquidity traps as households and businesses become unresponsive to ever easier interest rates.

And there is also the law of unintended consequences.

“The creation of policy scope to avert future crises could actually lead to asset bubbles (in real assets), which in turn would heighten the risk of future crises,” said William de Vijlder, chief investment officer at Fortis Investments. “A case of shooting ourselves in the foot if ever there was one.”

TOLERATION

De Vijlder, however, said that while the idea was clearly dismissed by euro zone officials, it may gain more traction in the United States -- where there is no official inflation target to begin with. Others would add Britain and Japan to that list.

And this difference of approach could have profound exchange rate implications over time, he argued.

But many experts, while acknowledging that higher official targets are unlikely, say governments will likely tolerate above-target inflation for a period in exchange for entrenching the recovery, boosting jobs and inflating away some of the huge sovereign debts incurred in ending the recession.

If the alternative to allowing some higher inflation is ever more savage cuts in government spending over the next 10 years, then the poor and old will suffer disproportionately in either case and the threat to social stability feared by many inflation hawks may well materialize in many countries anyway.

Economists at Barclays Capital say this temporary toleration -- in the United States, Japan and Britain at least -- would be a positive development for the global economy.

They point out that inflation, particularly core inflation excluding volatile food and energy prices, remains historically low and this will make the deep fiscal cuts commensurately harder and slower than previous episodes.

“Inflation has historically been a powerful force to deal with fiscal and real adjustments,” Barclays said.

They estimate that allowing inflation to accelerate to 5 percent would cut unemployment by 1.5 percentage points more than holding inflation at 2 percent. This drop in the number of jobless would be 3 points more if higher inflation was allowed over two years.

On the fiscal front, they argue, a similar higher inflation scenario would cut budget deficits by one percentage point of gross domestic product per year.

This -- and not the zero bound interest rate problem that Blanchard sets out -- is the main reason for co-habiting with higher inflation for a bit.

Neither winking nor wedlock then -- just sharing the bills for a bit.

Graphics by Scott Barber; Editing by Susan Fenton

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