Research undercuts Fed's two favorite U.S. inflation tools

The Federal Reserve building is seen in Washington June 19, 2012. REUTERS/Yuri Gripas

NEW YORK (Reuters) - Two tools that the Federal Reserve heavily relies upon to predict U.S. inflation in fact provide little practical help, and the Fed would be wise to only modestly overshoot its 2-percent price target, concludes a high-profile paper published on Friday.

The research, presented by five top economists to a small gathering of Fed officials and others in New York, focused on inflation’s slow-moving mean since 1984, a period of relatively stable prices and what is seen as mostly effective monetary policy. With prices now edging higher, the findings could inform how aggressively the Fed hikes interest rates this year.

The paper takes aim at two of the Fed’s favorite gauges to predict price swings - inflation expectations, which are derived from markets and surveys; and labor market “slack,” or the amount of workers actively looking for employment - and attempts to undercut their mystique.

Both “contribute very little to our ability to predict movements in inflation,” write the authors. “We are not claiming that slack and expectations are irrelevant; instead we are suggesting that in the current low-inflation environment they do not warrant any special status and should at least be augmented by a wider array of indicators.”

The Fed’s preferred inflation gauge has drifted below the target since 2008 and has moved relatively little in that time even while unemployment has fallen to less than half of its crisis-era high of 10 percent, a shift that has squeezed most or all of the slack from the labor market.

With inflation edging close to 2 percent, Fed officials aim to nudge rates higher this year so prices don’t overshoot. Fed Vice Chair Stanley Fischer and regional Fed presidents Charles Evans, Jeffrey Lacker and Robert Kaplan were among those at the forum on Friday, with some offering critiques.

The paper noted the Fed should aim for no more than a “modest” inflation overshoot, likely only a fraction of a percentage point over one or two years.

The authors were Peter Hooper of Deutsche Bank and Michael Feroli of JPMorgan, as well as professors Anil Kashyap of University of Chicago Booth School of Business, Stephen Cecchetti of Brandeis International Business School, and Kermit Schoenholtz of New York University Stern School of Business.

Reporting by Jonathan Spicer; Editing by Chizu Nomiyama