October 11, 2012 / 4:38 PM / 8 years ago

Fed's Plosser warns on sending the wrong inflation signals

AVONDALE, Penn. (Reuters) - The Federal Reserve’s stated intention to keep interest rates ultra low for nearly three more years is suggesting to some that the Fed is willing to cut the jobless rate at the expense of higher inflation, putting the central bank’s credibility at risk, a top official of the U.S. central bank said on Thursday

Charles Plosser, president of the Philadelphia Fed and one of the most hawkish of the Fed’s 19 policymakers, in a speech on Thursday weighed in on the simmering debate over just how high U.S. monetary policymakers would allow inflation to rise in order to boost weak economic growth and lower unemployment.

The debate has amplified - both among Fed policymakers and outside economists - since the policy-making Federal Open Market Committee (FOMC) last month launched a third and potentially massive round of asset purchases and said it expected to keep short-term borrowing costs near zero through mid-2015.

Plosser, in the text of a speech, said keeping the federal funds rate so low for so long “would risk destabilizing inflation expectations and lead to an unwanted” rise in inflation.

“In fact, some are interpreting the FOMC’s statement that we will keep accommodation in place for a considerable time after the recovery strengthens as an indication that the Fed is focused on trying to lower the unemployment rate and is willing to tolerate higher inflation to do so,” he said in a speech prepared for delivery to the Southern Chester County Chamber of Commerce, in Avondale, Pennsylvania.

“This is another risk to the hard-won credibility the institution has built up over many years, which, if lost, will undermine economic stability,” he said.

U.S. economic growth cooled in the second quarter to a tepid 1.3 percent annual rate, and forecasters do not think the economy is expanding much faster now. Though unemployment fell sharply to 7.8 percent last month, from 8.1 percent in August, analysts doubt that improvement can be sustained.

Inflation, meanwhile, has remained relatively stable near the Fed’s 2 percent target for almost three years. It is now tracking slightly below that target.

Since the Fed’s latest easing move, three of Plosser’s colleagues - Chicago Fed President Charles Evans, Narayana Kocherlakota of Minneapolis and John Williams of San Francisco - have each specified how high above 2 percent they would allow inflation to rise before tightening policy.

Economic theory suggests that higher inflation expectations have the same impact as easier monetary policy: lowering inflation-adjusted “real” interest rates, and encouraging borrowing, investment and hiring.

“We know that monetary policy can control inflation, but its ability to manage the unemployment rate is far more dubious,” said Plosser, who does not have a vote this year on Fed policy.

“Chasing an elusive goal for unemployment could well risk losing control over inflation,” he added. “That was the lesson of the Great Inflation during the 1970s.”

Reporting by Jonathan Spicer; Editing by Leslie Adler

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