Fed has a problem at heart of its battle to spark inflation

Bloomberg

There’s a flaw at the heart of central banking’s approach to inflation targeting that’s become a hot issue for the Federal Reserve as it takes a long, hard look at its strategy.
For decades, central bankers have pursued price goals while saying financial stability risks are better curbed by regulation. The contradiction is that monetary policy is often the most powerful fuel for asset bubbles as central bankers hold interest rates low to try and lift inflation that remains weak despite solid growth and rising productivity.
That describes the US today, with stocks trading at record highs and financial conditions easy.
“A big part of the policy rethink has to be making the costs and benefits of these trade offs more rigorous and explicit,” said Julia Coronado, founder of MacroPolicy Perspectives LLC in New York. “How much signal do they want to take from the turn down in core inflation given the growing leverage in the corporate sector that could make the next recession deeper?”
Central banks elsewhere have wrestled with striking that balance and the conflict resulted in the resignation in Sweden in 2013 of Riksbank Deputy Governor Lars E.O. Svensson. He stepped down after his colleagues ignored his calls for deeper rate cuts because they were worried about fuelling unsustainable credit growth.
Just last month Fed officials were divided over whether to raise a capital buffer on the largest banks. They’ll include a panel on financial stability at a Chicago conference in June on the conduct of monetary policy.
“If financial conditions ease, growth will be higher and monetary policy should respond” with tighter policy, said former Fed Governor Laurence Meyer. Yet central banks’ response to financial risk is often a story of “not yet, not yet, not yet – too late!’’
US central bankers sound intent on getting inflation higher, after missing their target almost continually since adopting it in 2012. Officials worry that if they can’t hit 2 percent inflation amid strong growth and low unemployment they may never get there.
Such concern was reflected in the Fed’s pivot to keeping rates on hold this year, which has boosted financial assets, and tilted the flow of money towards riskier investments. Larry Fink, the chief executive officer Blackrock Inc., the world’s largest asset manager, told CNBC on April 16 that the-re is greater risk of a stock market “melt up’’ than meltdown.
“Bloomberg Economics maintains the view that the Fed tightening cycle is not yet finished. The case for incremental additional tightening should become more evident as the data continue to strengthen and financial conditions ease,” said Carl Riccadonna, economist.
Economists expect the Fed to ignore market froth, leaving the policy rate on hold in a range of 2.25 percent to 2.5 percent at the conclusion of their meeting on Wednesday, while expressing concern over “muted” inflation. It’s a tricky subject for the Fed to navigate without sending mixed signals to the markets.
New York Fed President John Williams, prior to the rate hike in December, said an increase had the “added benefit’’ of reducing financial imbalances. As stocks plunged after the move, Williams said the Fed is “listening very carefully to what’s happening in markets.’’