The U.S. Federal Reserve's stated intention to keep interest rates exceptionally low for an extended period may conflict with its desire to avoid inflation, an academic economist told central bankers on Saturday.
The point of keeping interest rates low in the future is to promote economic activity today, but the price is a future rise in inflation, Carl Walsh of the University of California, Santa Cruz, wrote in a paper presented at the Kansas City Federal Reserve's annual Jackson Hole conference.
It is not clear how one has one without the other.
Walsh's audience includes Fed Chairman Ben Bernanke, European Central Bank President Jean-Claude Trichet and other central bankers from around the world gathered here in the shadow of the towering Grand Teton mountain range.
The U.S. central bank chopped its benchmark interbank lending rate target to near zero at the end of last year and has pledged to keep it low for a long time to revive the economy. It restated that expectation as recently as August 12, when it wrapped up its last policy meeting.
Near-zero interest rates and the Fed's aggressive efforts to pump of money into financial markets have raised concerns about sparking inflation.
The Fed has steadily sought to calm those fears by arguing it can keep inflation at bay by paying interest on the reserves banks hold at the Fed. By making it attractive for banks to keep their reserves out of play, the Fed would prevent that money from circulating and causing the economy to overheat.
The strategy of raising the interest rate the Fed pays to banks to pull money back from the system as the economy picks up may have pitfalls, Walsh wrote.
The perception that borrowing costs for households and firms are going up while the Federal Reserve is rewarding banks with higher interest on reserves may be less politically supportable, he said.
Central banks may need to keep their massive infusions of cash in place just beyond the point when economic activity begins to take off, but once they decide it is time to hike benchmark rates, they must act quickly and aggressively, Walsh said.
Following the crisis, central bankers may need to revisit some widely held beliefs, Walsh wrote.
One is the belief that a central should not lean against a growing asset bubble by raising borrowing costs out of concern interest rate hikes are too blunt an instrument that could damage the entire economy, he said.
There seems little doubt that the consequences of allowing the bubble in housing prices to continue was a serious policy mistake in the U.S. and many countries, Walsh wrote.
(Reporting by Mark Felsenthal; Editing by Neil Stempleman)