Fed research signals inflation overshoot possible, but is it tolerable?

By Howard Schneider

WASHINGTON (Reuters) - The Federal Reserve has begun preparing the public and markets for higher inflation, but has left unanswered the question of how high inflation might go and for how long.

A new research paper from economists at the Fed's Washington-based Board of Governors suggests that policymakers should allow prices to rise by around 3.0 percent annually during periods of high economic growth, so that the long-run average annual target of 2.0 percent inflation is achieved after several years of lower inflation.

"Achieving an inflation target of 2.0 percent hinges on policymakers pursuing inflation levels that are notably above 2.0 percent," when the economy is recovering, board economists Michael Kiley and John Roberts wrote in a paper presented Thursday at the Brookings Institution.

Keeping interest rates low while inflation spikes, presumably with output and wages also rising above potential, would "make up" for the accumulated effects of the long downturn in growth and inflation in the past decade.

Fed staff research does not necessarily reflect the views of board members or directly impact policy, but in this case it is relevant to an ongoing debate over how the Fed should react as inflation nears the central bank's target.

The personal consumption expenditure index, the Fed's preferred inflation measure, has averaged just 1.6 percent over the last decade, prompting some support for a period of higher inflation in hopes that wages and interest rates may rise as well.

Fed Chair Janet Yellen last week, and a group of regional reserve bank presidents this week, signaled the Fed would not try to halt inflation at 2.0 percent, but only shift gears if above-target prices rises appear "persistent."

"Two percent is not a ceiling," Chicago Federal Reserve bank president Charles Evans said in New York this week. "If you always worry about spending time above 2.0 percent, that's smelling and tasting and looking like a ceiling - and I think that's something you have to actively fight."

The papers on inflation and other topics, prepared by top Fed and other economists for an annual Brookings research conference, showed that even as economic conditions become more normal the Fed is continuing with a deep re-evaluation of economic conditions following the 2007-2009 financial crisis.

The papers outlined the likely persistence of slow economic growth in an aging society, countering the notion that a faster economy is just a tax cut away, and the likelihood that global interest rates will remain lower than usual for a long time to come.

In the current Fed debate, acceptance of 3.0 percent inflation is unlikely. The 2.0 percent goal is a global norm for central banks, a recognition that a modest but steady rise in prices is actually healthy for the economy overall.

Prices that rise too fast can trigger a public outcry, and may risk changing household and business psychology in a way that fuels even faster price increases and which can be hard to tame.

However the Fed did change its policy language slightly, but significantly, last week when it said that the 2.0 percent annual inflation target was "symmetric." After years of low inflation, officials said, an overshoot will not lead them to change course and raise interest rates faster than the "gradual" path they currently intend.

Under current Fed forecasts, that means interest rates will remain low enough to encourage borrowing and spending for perhaps three more years as the Fed slowly climbs back to a "neutral" interest rate estimated at around 3.0 percent.

In an economy that is near or below full employment, wages should rise as firms compete for workers, one of the possible benefits of a "hot" economy that Yellen last fall suggested researchers should try to analyze.

Policymakers have not set a path for how "hot" the economy might be allowed to run, but Minneapolis Fed President Neel Kashkari, in a public Twitter conversation this week, said an extended inflation overshoot of 2.3 percent would be tolerable "if we really believe 2 percent is a target".

(Reporting by Howard Schneider)