* IMF thinks aloud on raising inflation targets to 4 pct
* Core inflation in developed world set for historic low
* Higher inflation may be tolerated rather than targeted
By Mike Dolan
LONDON, Feb 24 (Reuters) - International Monetary Fund murmurs that central banks should consider higher inflation targets will disconcert price hawks, but the idea may reveal risks that financial markets have yet to confront.
Despite the persistence of unprecedented monetary stimulus, money-printing and ballooning government debts, investors appear relaxed about the prevailing and future inflation environment. The latest official numbers, at least, seem to back that up.
Even though headline inflation has jumped back in recent months, "core" price rises that strip out volatile food and energy and one-off hikes remain historically subdued in the United States and other major developed economies.
JPMorgan reckons annual core inflation in the developed economies bloc, now just 1 percent, will fall to record lows near 0.5 percent later this year. What is more, 10-year inflation expectations, derived from the index-linked government bond markets, remain subdued at about 2 percent or less in the United States, euro zone and Japan. Only in Britain have they pushed higher this year to top 3 percent.
But it is at least partly this low inflation environment that seems to have prompted the IMF to start thinking out loud. A research paper co-authored by IMF chief economist Olivier Blanchard, and released by the IMF this month, posed a number of challenges to orthodox economic policymaking in the light of the recent financial crisis and deep global recession.
Chief among questions raised in the paper was whether central bankers might consider raising inflation targets to 4 percent from the long-standing "magic" 2 percent -- espoused for decades as the effective definition of price stability.
Blanchard et al's line is simple. Faced with shocks like the recent credit crisis, a 2 percent target may be too low.
As nominal interest rates can't go below zero, an inflation rate of 2 percent limits the extent to which central banks can cut real, or inflation-adjusted, rates into negative territory to offset steep drops in output and subsequent fiscal blowouts.
"Are the net costs of inflation much higher at say 4 percent than at 2 percent?" the paper asked rhetorically. "Is it more difficult to anchor expectations at 4 percent than 2 percent?"
While acknowledging the risks and costs of higher inflation, they asked "whether these costs are outweighed by the potential benefits of avoiding the zero interest rate bound."
The paper, entitled "Rethinking Macroeconomic Policy", is laced with disclaimers distancing it from official IMF thinking. But it appears to represent a debate that the Fund is opening up on macro policy generally -- one that includes a seeming growing acceptance at the IMF of temporary capital controls in developing nations.
TWO AND TWO EQUALS
That said, taken literally for the sake of argument, some economists reckon that for the major central banks to pursue explicit 4 percent inflation targets now would require near-zero interest rates and super-accommodative monetary policies for much longer than currently assumed.
This in itself would limit room for manoeuvre if there were a fresh shock to the system or double-dip global recession over coming year or two, they say.
Moreover, any public announcement of higher targets could create a shock of its own to markets and wage bargainers -- coming as it does some 2 percentage points above where U.S. and euro bond investors see inflation over the next decade.
Nevertheless, many economists say 4 percent inflation -- targeted or not -- may actually be closer to the long-term price reality than markets are currently taking on board.
Explicit central bank targets may well stay where they are, but policymakers may have little choice but to tolerate higher inflation as way of coping with sluggish real growth, a fragile financial system and extreme public indebtedness.
"The gap over time between what is needed in terms of nominal growth and what is available in terms of real growth will likely be made up by creeping inflation," said Deutsche Bank Chief Economist Thomas Mayer.
"What we'll likely see is an implicit loosening of the target because central banks are now boxed in between price stability mandates on one hand and a need to preserve financial stability and government solvency on the other," said Mayer.
"They cannot pursue just one objective any more. In the end, we may well see the sort of inflation rates Mr Blanchard is talking about coming through."
INFLATION MIRAGE
To be sure, if targeting a little bit more inflation could solve the deep budgetary problems bequeathed by the credit crisis, it may seem to some a price worth paying.
But even that assumption is questionable given the problems creeping inflation could sow for inflation-linked public spending commitments and bond market servicing costs.
Morgan Stanley's U.S. economist Richard Berner reckons that in the United States at least: "Inflation is not the solution."
Bond markets would baulk. The Federal Reserve would resist.
And one of the biggest deterrents to allowing higher inflation is the deficit-boosting impact on Federal spending due to the index-linked nature of Social Security and Medicare/Medicaid spending -- which together account for nearly half of all Federal outlays in the next decade.
"Sovereign credit risk may create inflation risk, but perhaps not for years," said Berner. "The more immediate pressures may instead vent in rate or currency risk."
(Editing by Ruth Pitchford)
(London newsroom, +44 207 542 8488. Email:mike.dolan@reuters.com))