Inflation flashing red may be less of a green light for higherinterest rates as global growth falters.

Some Federal Reserve policy makers favor keeping their benchmarkrate close to zero until price increases reach a level VincentReinhart, a former top official, says could be 3 percent. The Bankof England has held its key rate at a record low even as U.K.inflation breached its 2 percent target for 21 months. Brazilexecuted a surprise cut Aug. 31 to safeguard its economy even afterinflation quickened to a six-year high.

Policy makers such as Fed Chairman Ben S. Bernanke and Bank ofEngland Governor Mervyn King may be challenging central-bankorthodoxy to replenish depleted toolkits and support recoveries atrisk of sliding back into recession. Tolerating higher inflationmay make long-term Treasuries less attractive while supportingstocks and commodity prices, said Jim Kochan, chief fixed-incomestrategist at Wells Fargo Advantage Funds.

“There's a hint of desperation here,” said Kochan, who helpsmanage $216 billion in Menomonee Falls, Wisconsin. “They're clearlyconcerned that monetary policy to date hasn't really accomplishedwhat they expected it to. So they ask themselves, why? And whatcould we do about it?”

If adopted, the strategy might be called “Generate InflationNow,” or GIN, Reinhart said, a reversal of the FordAdministration's “Whip Inflation Now,” or WIN, program in the1970s.

'Cutoff' Question
“Everybody knows highinflation is bad,” said Reinhart, the Fed's director of monetaryaffairs from 2001 to 2007 who will become Morgan Stanley's chiefU.S. economist in October. “Nobody is sure of where the cutoffis.”

Bernanke and his Federal Open Market Committee gather tomorrowin Washington for a two-day meeting and will issue a statementSept. 21 at 2:15 p.m. New York time. Some economists anticipateadditional stimulus aimed at reducing long-term borrowing costs andboosting growth. The Fed cut the target for its benchmark federalfunds rate almost to zero in December 2008 and has since purchased$2.3 trillion of bonds.

The FOMC at its Aug. 9 meeting considered conditioning itspledge to keep interest rates at record lows “on explicit numericalvalues for the unemployment rate or the inflation rate,” accordingto minutes released Aug. 30. The commitment should be contingent onjoblessness falling to around 7 percent or 7.5 percent as long asinflation stays below 3 percent in the medium term, Charles Evans,president of the Federal Reserve Bank of Chicago, said in a Sept. 7speech.

Focus on Core
Unemployment was 9.1 percent inAugust, and the Fed's preferred inflation gauge, which excludesvolatile energy and food prices, rose 1.6 percent in July. Policymakers should focus on core inflation to better reflect trends thatare “likely to be sustained over the medium term,” theInternational Monetary Fund said in a chapter of its World EconomicOutlook released Sept. 14, ahead of its annual meeting of centralbankers and finance ministers this week.

Columbia University's Michael Woodford and Harvard University'sKenneth Rogoff are among proponents of faster price increases,which should result in lower interest rates adjusted for inflation.This might stimulate spending, along with a side effect of helpingpare record debt loads.

While computer simulations imply this strategy will work, it'suntested in the real world, said Woodford, a professor whoco-taught economics with Bernanke at Princeton University. Therehas been “nervousness” among central bankers about saying “youwould allow inflation,” he said. Now “there's at least morewillingness to discuss the issue.”

Faltering Growth
Consumer prices worldwidemay rise at a slower pace after jumping earlier this year asfaltering economic growth drags down food and energy costs.JPMorgan Chase & Co. economists estimate inflation in developedmarkets will average 1.3 percent in the second quarter of 2012,down from 2.7 percent in the same period this year.

The Fed should get U.S. prices back to the path they were onbefore the September 2008 collapse of Lehman Brothers HoldingsInc., Nobel laureate Roger Myerson at the University of Chicagosaid Aug. 23 on Bloomberg Television.

According to Bloomberg calculations, the central bank would needto generate annual inflation of 3.3 percent in the two yearsthrough July 2013 to return to a hypothetical 2 percent path sinceJuly 2008, under the Commerce Department's personal consumptionexpenditures price index. This gauge rose 2.8 percent in July froma year ago.

Weaker Currencies
Changing policy to toleratehigher inflation means lower bond prices in the long run and weakerdeveloped-market currencies, including the dollar and pound,against emerging markets, said Stephen Jen, managing partner at SLJMacro Partners LLP in London.

Wells Fargo's Kochan and Pacific Investment Management Co.'sAnthony Crescenzi agree bond prices would suffer. If the Fedsuccessfully implemented this strategy and European officialsmanaged to contain the continent's sovereign-debt crisis, two-yearyields, which traded at a record low of 0.1512 percent today, mightbe little changed, while 10-year rates increased to a range between3 percent and 4 percent within two or three years, said Crescenzi,who helps manage $1.3 trillion as executive vice president at Pimcoin Newport Beach, California.

Yields on 10-year Treasuries were at 1.99 percent at 9:56 a.m.in London today. U.S. debt was the best-performing asset class inAugust as bond investors ignored Standard & Poor's Aug. 5decision to strip the U.S. of its AAA rating. Treasuries returned2.8 percent, while the global bond market gained 1.99 percent, Bankof America Merrill Lynch index data show.

Economic Benefits
Crescenzi cautions thatfaster inflation may not produce the economic benefits proponentsproject, instead reducing the amount of goods and serviceshouseholds and businesses could buy. That would cut production —and eventually incomes.

“It would turn a virtuous cycle into vicious,” he said. “I seeit as quite negative.”

Central banks with a target also may have to squelch priceincreases later, risking harm to growth and “a seriousdisinflation,” said Raghuram Rajan, former IMF chief economist anda professor at the University of Chicago's Booth School ofBusiness.

More than 20 central banks have adopted some type of inflationtarget since the Reserve Bank of New Zealand pioneered the strategytwo decades ago. Such targets help control expectations of futureprice pressures and provide clarity about the direction of interestrates.

Failed to Prevent
The strategy nonethelesstook a hit for failing to anticipate or prevent the worst economiccrisis since the Great Depression. In the future, inflation targetsshould be coupled with a tool that helps deliver financialstability, a report sponsored by the Brookings Institution saidlast week.

The Bank of England has left its benchmark rate at 0.5 percentsince March 2009. While inflation may reach 5 percent in the nextfew months, it might have been below the bank's 2 percent targetwithout temporary shocks such as this year's oil-price spike, Kingsaid in an Aug. 15 letter to Chancellor of the Exchequer GeorgeOsborne.

The U.K. eventually may want to adopt a goal that accounts forstronger global price pressures, said Simon Hayes, chief U.S.economist at Barclays Capital.

Any change at the Fed would face opposition at the U.S. centralbank, where policy makers favor a long-run inflation goal of 1.7percent to 2 percent, according to their most recent economicprojections in June.

'Meager Savings'
Richard Fisher, president ofthe Federal Reserve Bank of Dallas, told reporters Sept. 12 hecouldn't imagine trying to explain the shift to unemployed workersand others “who don't want their income or meager savings eroded byprice increases.” He was one of three officials to dissent from theAugust decision to keep rates near zero through at leastmid-2013.

Of 27 central banks Morgan Stanley monitors with formal orinformal targets, 15 now face inflation running above their aim.Some emerging-market officials may be sacrificing their goal tosupport economic growth or financial stability, Peter AttardMontalto, an economist at Nomura International Plc in London, saidin a Sept. 12 report that identified Turkey and Hungary.

Brazil cut its benchmark rate to 12 percent on Aug. 31 asconsumer prices rose 7.23 percent from a year earlier. While theincrease exceeded the 6.5 percent upper limit of the bank's targetrange for a fifth straight month, officials remain committed to thepolicy and price increases will start to ease, President AlexandreTombini, said Sept. 8.

German Legacy
Among developed countries, theEuropean Central Bank has proved less tolerant of faster priceincreases — a legacy of Germany's hatred of the inflation oftenblamed for weakening democracy in the 1920s and aiding AdolfHitler's rise to power.

The Frankfurt-based central bank, which aims to keep inflationjust below 2 percent, raised its benchmark rate twice this year, to1.5 percent, even as the Greek-led debt crisis threatenedexpansion. With economies slowing, President Jean- Claude Trichetsaid Sept. 8 that price risks are “broadly balanced” in the mediumterm, despite inflation at 2.5 percent in August.

More central banks may make similar efforts to “explain away”the temporary nature of inflation as a reason to ignore it, saidJen, a former IMF economist. Policy makers “will put more emphasison growth,” he said.

Bloomberg News

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