With the US Federal Reserve considered likely to nudge interest rates up again, global bond manager PIMCO has said that it would be better off widening the range in which it tries to manage cyclical inflation to have greater flexibility in handling secular, or long-term, inflation.

In its latest note to clients, PIMCO managing director, Paul McCulley, argues that not only should Reserve chairman Ben Bernanke announce his Optimal Long-term Inflation Rate (OLIR) target, as he has proposed, but also that this should be in a range of 1.5 per cent to 3 per cent, rather than the “too narrow” range of 1.5 per cent to 2 per cent, as has been suggested. In a speech to the Money Marketeers Club in New York last month, McCulley said the Fed seemed to focus on maintaining inflation within a very tight band, regardless of where the economy lay within the cycle. McCulley argued that risk premiums had been squeezed out of the market as a result of the Fed’s effectiveness in controlling inflation and that, counter intuitively, Fed policy has become less efficient as a result. As such, McCulley argues that the Fed could become both more transparent and more effective in their operations by focusing more on long-term inflation trends rather than shorter-term inflation aberrations. He says that this would create both short-term efficacy of Fed policy and long-term stability within financial markets. McCulley warned, in his speech, that if the Fed continued to follow its rigid short-term policy it faces asymmetric deflation risk. If risk premiums got very thin based on short-term predictability of Fed policy and the current market state followed the historical fact that the market had not dealt kindly with protracted periods of low risk premiums, then the Fed might find themselves in a position where they were left without an asset bubble to inflate and faced the secular risk of deflation. McCulley said: “I believe more cyclical variability in inflation around a low secular mean would actually enhance the Fed’s ability to secularly maintain that low mean, as the Fed’s asymmetric reaction function to asset price bubbles ironically increases the long-term risk on the deflationary side of the OLIR… “While I am four-square behind chairman Bernanke’s proposal to define and announce the OLIR, I am strongly against defining a tolerable cyclical band around it that is too narrow. “Irony is as irony does. A little more cyclical variability in inflation would enhance the odds of secular stability in inflation.”

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