Fed turns attention again to U.S. inflation outlook as key risk

By Jason Lange and Ann Saphir

WASHINGTON (Reuters) - After months of noting that inflation was very low, but voicing confidence it would eventually trend toward Federal Reserve's target, Chair Janet Yellen appears to be acknowledging that the central bank does have an inflation problem.

The Fed's apparent renewed focus on prices after months of close scrutiny of the labor market could indicate that it may end up keeping rates on hold for longer than its policymakers' forecast now indicate.

Even as Yellen repeated her mantra that the first rate rise in nearly a decade was still on the cards for this year she cited a drop in market-based inflation expectations over the past month as source of concern.

"That's something that has caught our attention," Yellen told journalists on Thursday after the central bank kept rates on hold.

The Fed had noted investors' declining inflation expectations before, most recently in January. Yet since taking over the Fed's helm early last year Yellen has repeatedly expressed skepticism over how reliable market-based measures were as a gauge of long-term inflation expectations.

On Thursday she repeated some of the caveats, saying market gauges were being distorted by changes in market liquidity and other factors, but added they were "a factor that we're watching."

Since August, when worries over China's economic health and a global slowdown roiled financial markets, investors ramped up bets that inflation will remain below the Fed's 2 percent target even 10 years from now, reflected in prices of inflation protected securities (TIPS).

“The way she highlighted TIPS suggests that they are thinking about it again," said Lewis Alexander, a former deputy director of the Fed's international finance division and now Nomura's chief U.S. economist.

Investors now expect inflation to average 1.9 percent between 2020 and 2025 compared with 2.1 percent in June.

VEXING PUZZLE

Yellen is due to give a speech on inflation on Sept 24 that could signal new thinking at the U.S. central bank on a puzzle vexing its policymakers: Why are prices rising so slowly despite rapidly declining unemployment?

One potential answer, which emerged from discussions at a Fed conference in August, is that what happens in the global economy and financial markets has a greater impact on U.S prices than policymakers previously thought.

Fed officials had previously played down the effects of falling energy prices and a stronger dollar as transitory.

Yellen said on Thursday the Fed would not raise interest rates until it "has a good degree of confidence" inflation will rise back toward target.

Out of 17 Fed policymakers 13 forecast that they will be able to lift rates from near zero sometime later this year, but Randy Kroszner, a Fed governor in 2006-2009, said the fact that Yellen brought up inflation expectations suggested the Fed was less confident than before.

"Obviously that's giving them pause," Kroszner told Reuters.

He said declining market-based inflation expectations helped push the Fed to ease policy when he was a policymaker during the crisis and the recent falls appeared to be getting in the way of a key condition the Fed wants met before it hikes.

“They are probably less confident that they are going to be reaching their 2 percent goal,” he said.

The Fed wants prices to rise 2 percent a year to fend off a risk of deflation, a downward spiral of declining prices, spending and investment that is hard to arrest, something Japan has struggled with for two decades. But inflation has been undershooting the goal for most of the time since 2008 and in the 12 months through July prices rose just 0.3 percent thanks to a plunge in global oil costs.

Inflation is a phenomenon central banks once thought they could largely understand and control. Today, confronted with price growth undershooting rather than exceeding targets, policymakers are struggling with the task of bringing inflation back to levels considered appropriate for a healthy economy.

Minneapolis Fed President Narayana Kocherlakota, who has been repeatedly sounding alarm about risks posed by low inflation, reiterated his concerns at the Fed's annual conference at its mountain retreat in Jackson Hole, Wyoming.

"I visited the Bank of Japan last year and had the opportunity to talk to members of their monetary policy committee," he told Reuters in an interview. "And my main takeaway is: you do not ever, ever want to be in that situation that they find themselves in now. So when I think about policy, that's the risk I see as the one to avoid."

(Editing by Tomasz Janowski)

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