Fed's Pianalto Says Longer-Term Inflation Trend Too High

Inflation hovering around 3% in the United States since 2005 is too high for comfort in the longer term, Cleveland Federal Reserve President Sandra Pianalto said on Wednesday.

In a speech before a Bundesbank conference on monetary policy strategy, Pianalto said that high commodity and oil prices, which have been pushing up inflation, risk undermining the public's trust in the central bank's inflation-fighting mettle.

"Since 2005, the three- to five-year moving average of U.S. inflation has hovered around 3%. This is above where I would like to see the trend settle in the longer run," she said.

"The reality of rising oil and commodity prices is evident, and my Federal Reserve colleagues and I have been clear about our belief that the impact of these influences will dissipate over time. But until our beliefs are validated by the data, there is a risk that the public's trust could erode and inflation expectations could move higher."

Her remarks were in line with the firm anti-inflationary stance the Fed has held, despite market expectations that the Fed will have to lower its borrowing costs from 5.25% in face of a housing market slowdown that is weakening the economy.

U.S. consumer inflation in April slipped to 2.6% year-on-year from 2.8% percent the previous month, but surging oil prices over the past few years have sent it above 3% recently.

Failure to anchor inflation expectations solidly when confronted with a large and persistent price shock is one of three challenges that a central bank faces in confronting potential inflationary risks, Pianalto said.

Liquidity Crises

The second inflationary risk a central bank should be prepared for is the need to slash interest rates when faced with extraordinary liquidity needs, such as the financial market upset from the Asian and Russian debt crises in 1998, she said.

"I think this is the appropriate response to financial market turmoil, but in any given case there are still questions of how much to intervene, and for how long. How those questions are answered can have longer-term consequences for inflation expectations," she said.

The Fed cut rates after the near-collapse of Long Term Capital Management in the wake of the Asia crisis, and it held them low to address global financial conditions until June 1999.

The result was that it delivered its last tightening move at the very time that industrial aduction was peaking, she said.

"With the benefit of hindsight, it seems likely that the policy environment of the time was complicated by the fact that inflation expectations were on the rise," Pianalto said.

The third inflationary risk for central banks to weigh is government budget deficits. "If fiscal deficits do not improve, central bankers could once again face the difficult challenge of attaining price stability in a world where expectations are moving in the wrong direction," she said.

The U.S. government has started to reduce its huge budget deficit, which the White House estimates at $200 billion this year. Already it has shrunk by 22.3% in fiscal year 2006 to $247.7 billion. Similarly, European governments are trying to lower their budget deficits to give more leeway to handle the demands of an ageing population.

Faced with the three-fold challenge, Pianalto said central bankers are still learning the best response to containing inflation expectations.

On this score, a track record of low inflation is not sufficient. Communication of a central bank's commitment to its price stability objective also plays an important role, she said. The Federal Reserve has been reviewing its communication strategy since Ben Bernanke took the helm of the central bank.

"I continue to be optimistic that central bankers will successfully meet the challenges that lie ahead. And indeed, inflation expectations appear to be well anchored. But we cannot afford to be complacent," Pianalto said.