US Fed Reserve flirting with higher inflation

Will the U.S. Federal Reserve look the other way if inflation overruns its target?

Risking the wrath of politicians and the central bank's hard-won reputation for keeping prices stable, three top Fed officials are touting plans for boosting employment that explicitly allow for inflation to run above the Fed's 2.0-percent goal.

Investors are wondering just how high - and for how long - the Fed may allow inflation to rise to encourage borrowing, investment and hiring. In theory, more people working means higher output, which should narrow the gap between what American workers are currently producing and their potential.

"The Fed's body language clearly says they think the output gap is huge and that they're willing to take risks on inflation," said Bluford Putnam, chief economist at futures exchange operator CME Group.

The Fed reduced official interest rates to near zero almost four years ago and has since then bought some $2.3 trillion in securities to boost the economy, taking the central bank deeper into uncharted policy territory.

With the U.S. economy still recovering only slowly, last month the Fed said it would keep buying bonds until the labor market outlook improves "substantially," a move that many investors expect will boost inflation, currently running below the 2.0 percent target.

Since the announcement, the central bank's top policymakers have been busy drawing their lines in the sand.

Minneapolis Fed President Narayana Kocherlakota says he would tolerate inflation of 2.25 percent, and John Williams of the San Francisco Fed says he's OK with 2.5 percent. The Chicago Fed's Charles Evans, considered one of the central bank's most pro-growth "doves," says he'd hold fast to low rates as long as the outlook for inflation stayed below 3 percent.

Volatility in bond markets suggests investors are adjusting their bets as to the true intentions of Fed Chairman Ben Bernanke and his core of policymakers, and whether they will be able to control inflation when the time comes.

"I wouldn't be surprised if they let it run to 3.0 percent for a quarter or two and still rationalize that by saying they still haven't seen unemployment go down like they want it to," said Mike Knebel, portfolio manager specializing in fixed income at Ferguson Wellman Capital Management in Portland, Oregon.

"Three percent still seems to be a fairly reasonable number in most people's minds - at least those of us who are old enough to remember when six percent was considered the norm," he said.