By Jason Lange
NEW YORK (Reuters) - The Federal Reserve should be willing to let inflation temporarily run above its target level so as to more quickly bring the economy back to health, a top Fed official said on Friday, even as a second policymaker signaled the very idea left him cold.
The debate, between Chicago Fed President Charles Evans and Philadelphia Fed President Charles Plosser, underscored a fundamental disagreement over the central bank's optimal approach to policy under new Fed Chair Janet Yellen.
To Evans, one of the Fed's most dovish policymakers, allowing inflation to run above the Fed's 2-percent target would be a small price to pay for bringing the U.S. economy back to full employment quickly, and could even signal the Fed's commitment to making good on its goals.
To Plosser, an ardent policy hawk, letting inflation rise above the target would call into question the Fed's commitment to its goals, undermining its policy effectiveness.
How the debate plays out could have a huge impact on the course of Fed policy as Yellen prepares to chair her first policy-setting meeting next month, particularly as policymakers debate ways to retool a low-rate promise that both hawks and doves see as in need of a serious overhaul.
Under Yellen's predecessor Ben Bernanke, the Fed used massive bond-buying programs and a promise to keep rates low to boost the economy despite having already slashed the main policy rate to near zero.
But with unemployment still too high and inflation undesirably low, Evans said on Friday the U.S. central bank's policy-setting Federal Open Market Committee is still falling short on both of its goals.
"If anything, the FOMC has been less aggressive than the policy loss function might admit," Evans told the University of Chicago's Booth School of Business conference on monetary policy in New York.
The Fed has made it clear that an unemployment rate of about 5.5 percent and an inflation rate of about 2 percent are indicative of a healthy economy, he said. Bringing the economy back to health slowly poses risks because of the chance of intervening policy shocks, Evans said.
"The surest and quickest way to get to the objective is to be willing to overshoot in a manageable fashion," Evans said. "With regard to our inflation objective, we need to repeatedly state clearly that our 2 percent objective is not a ceiling for inflation."
Speaking after Evans on the same panel, Philadelphia Fed chief Plosser warned that if the Fed fails to treat its guidance as goals, its credibility will fall by the wayside and so will its policy effectiveness.
The Fed has promised to keep interest rates near zero until well past the time that the unemployment rate reaches 6.5 percent, as long as inflation does not threaten to rise above 2.5 percent.
With the U.S. jobless rate now at 6.6 percent, the Fed's unemployment threshold has become irrelevant, Plosser said. That's an assessment with which Evans has said he agrees.
But, Plosser added, the public could also come to doubt the Fed's seriousness about its inflation safeguard.
"In other words," he said, "by allowing the unemployment threshold to pass without taking action, the public might conclude that the Committee could easily decide to let the inflation threshold pass without taking action as well."
To Plosser, that would be problematic. The Fed must have "some degree of commitment to abide" by its promises, Plosser said on Friday: too much flexibility could undermine the Fed's policies.
Meanwhile another top Fed official on Friday said concern that loose monetary policy was fueling financial instability was not a pressing issue and that there was enough slack in the economy to give the U.S. central bank two to three years to mull the problem.
"We don't need this theory to be able to make decisions in March of 2014," Minneapolis Federal Reserve Bank President Narayana Kocherlakota said in a reference to growing concerns among his colleagues that loose monetary policy could be fueling financial instability.
The economy remains weak, he said, so "I think we have two to three years to be thinking of this problem."
After more than five years of super-easy monetary policy in the wake of the 2007-2009 recession, the Fed is taking the first small steps toward a more normal interest-rate environment. It trimmed its bond-buying program by $10 billion in each of the past two months, and it expects to raise interest rates sometime next year as long as the economy continues to improve.
Recent bad weather in large portions of the United States has slowed economic growth recently, but top Fed officials remain optimistic about economic prospects.
Even if the recent spate of soft data is entirely unrelated to weather, St. Louis Federal Reserve President James Bullard told CNBC television on Friday he is still optimistic about the economic growth outlook.
"I'd still project that 2014 would have stronger GDP growth than 2013 did and I'd still project that inflation would come back to target," Bullard said.
On Thursday, Yellen attributed much of the recent weak economic data to bad weather and suggested that only a significant change in the economic outlook would drive the Fed to reconsider its plan to wind down its massive bond-buying program this year.
Dallas Fed President Richard Fisher, speaking in Zurich on Friday, wholeheartedly embraced that plan.
"As soon as feasible, the Federal Reserve should stop large-scale asset purchases entirely," said Fisher, who has a vote on the Fed's policy panel this year.
The Texan is one of the most outspoken opponents of the current round of bond buying, which has swollen the Fed's balance sheet to more than $4 trillion.
(Reporting by Susan Heavey, Jason Lange, Bill Trott, Alice Baghdjian and Katharina Bart; Writing by Ann Saphir; Editing by Andrea Ricci and Meredith Mazzilli)