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Fed's Brainard Says Central Bank Should Welcome Modest Rise in Inflation--Update

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05/16/2019 | 12:43pm EDT

By Nick Timiraos

WASHINGTON -- A top Federal Reserve official said Thursday the central bank's commitment to maintaining stable prices would benefit from a modest rise in inflation over the coming years, an indication the central bank wouldn't need to raise interest rates should inflation increase.

Fed governor Lael Brainard said underlying inflationary pressures, after filtering out transitory and idiosyncratic factors, "appears to be somewhat below" the Fed's 2% goal, a surprising development given continued declines in unemployment.

Ms. Brainard didn't say whether the Fed should consider cutting interest rates to boost inflation in her prepared remarks at a tax policy conference in Washington, a possibility raised by some Fed officials in recent weeks.

"It is not entirely clear how to move underlying trend inflation smoothly to our target on a sustained basis in the presence" of forces that have made inflation less responsive to tighter labor markets, she said.

Excluding volatile food and energy categories, inflation measured by the Fed's preferred gauge rose 1.6% from a year earlier in March, down from 1.8% in January and 2% in December.

Ms. Brainard said one way to better achieve the Fed's 2% target might be to take advantage of a so-called "opportunistic reflation," in which the Fed would seek a modest overshooting of its 2% goal "for a couple of years."

"The Federal Reserve could use that opportunity to communicate that a mild overshooting of inflation is consistent with our goals and to align policy with that statement," said Ms. Brainard.

Ms. Brainard described the economy as relatively healthy in her remarks, calling attention to a "strong" labor market and confident consumers. One area of concern is trade, which she said is "creating uncertainty."

Between 2015 and 2018, the central bank raised rates on the theory that declining unemployment and disappearing slack across the economy more broadly would eventually generate stronger inflation.

Though inflation was running below the Fed's 2% target, this framework reflected confidence it would pick up, requiring pre-emptive rate increases to keep it from taking off. In particular, officials last year anticipated that tax cuts and federal spending increases would push inflation above the target.

Ms. Brainard as recently as last September suggested the Fed would need to raise rates to a level designed to slow the economy.

Ms. Brainard's remarks on Thursday called for a rethink. "The historical relationship between resource slack and price inflation appears to have broken down," she said. While wages are rising as labor market slack fades, price pressures have remained muted.

Fed officials are particularly sensitive to households' and businesses' expectations of future inflation because they believe this plays an important role in setting actual prices. Ms. Brainard said it would be especially important to ensure that inflation expectations don't drift lower.

"Because inflation is ultimately a monetary phenomenon, the Federal Reserve has the capacity and the responsibility to ensure inflation expectations are firmly anchored at -- and not below -- our target," she said.

One consequence of such a breakdown is that interest rates will remain lower than in previous business cycles, raising the risk of imbalances in financial asset markets, she said. That calls for a more robust use of regulatory tools to boost bank capital.

"Now is a bad time to be weakening the core resilience of our largest banking institutions or to be weakening oversight over the nonbank financial system," she said.

Because the financial cycle is likely to be "tempered less than in the past by material increases in interest rates as the economy expands, the appropriate level of bank capital for today's conditions is unlikely to be the same as in past business cycles," she said.

Write to Nick Timiraos at nick.timiraos@wsj.com

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