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Fed's Plosser warns on sending the wrong inflation signals

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AVONDALE, Penn., Oct 11 (Reuters) - The Federal Reserve'sstated intention to keep interest rates ultra low for nearlythree more years is suggesting to some that the Fed is willingto cut the jobless rate at the expense of higher inflation,putting the central bank's credibility at risk, a top officialof the U.S. central bank said on Thursday

Charles Plosser, president of the Philadelphia Fed and oneof the most hawkish of the Fed's 19 policymakers, in a speech onThursday weighed in on the simmering debate over just how highU.S. monetary policymakers would allow inflation to rise inorder to boost weak economic growth and lower unemployment.

The debate has amplified - both among Fed policymakers andoutside economists - since the policy-making Federal Open MarketCommittee (FOMC) last month launched a third and potentiallymassive round of asset purchases and said it expected to keepshort-term borrowing costs near zero through mid-2015.

Plosser, in the text of a speech, said keeping the federalfunds rate so low for so long "would risk destabilizinginflation expectations and lead to an unwanted" rise ininflation.

"In fact, some are interpreting the FOMC's statement that wewill keep accommodation in place for a considerable time afterthe recovery strengthens as an indication that the Fed isfocused on trying to lower the unemployment rate and is willingto tolerate higher inflation to do so," he said in a speechprepared for delivery to the Southern Chester County Chamber ofCommerce, in Avondale, Pennsylvania.

"This is another risk to the hard-won credibility theinstitution has built up over many years, which, if lost, willundermine economic stability," he said.

U.S. economic growth cooled in the second quarter to a tepid1.3 percent annual rate, and forecasters do not think theeconomy is expanding much faster now. Though unemployment fellsharply 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 nearthe Fed's 2 percent target for almost three years. It is nowtracking slightly below that target.

Since the Fed's latest easing move, three of Plosser'scolleagues - Chicago Fed President Charles Evans, NarayanaKocherlakota of Minneapolis and John Williams of San Francisco -have each specified how high above 2 percent they would allowinflation to rise before tightening policy.

Economic theory suggests that higher inflation expectationshave the same impact as easier monetary policy: loweringinflation-adjusted "real" interest rates, and encouragingborrowing, investment and hiring.

"We know that monetary policy can control inflation, but itsability 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 risklosing control over inflation," he added. "That was the lessonof the Great Inflation during the 1970s."

(Reporting by Jonathan Spicer; Editing by Leslie Adler)

((jonathan.spicer@thomsonreuters.com)(+1 646 223 6253)(ReutersMessaging: jonathan.spicer.reuters.com@reuters.net))

Keywords: USA FED/PLOSSER