U.S. Fed should try to break boom-bust cycle, says ex-RBNZ chair

By David Milliken

LONDON (Reuters) - The U.S. Federal Reserve should try to stop a damaging cycle of booms and busts by breaking investors' expectations that it will mop up after future asset price bubbles, one of the pioneers of inflation-targeting said.

Arthur Grimes, who developed inflation-targeting at the Reserve Bank of New Zealand in the late 1980s, said the Fed had inadvertently made bubbles more likely by promising to help the economy after they burst.

"The largest economy in the world is leading policies that lead to asset booms. It makes it incredibly difficult for other central banks to have a credible policy," he told Reuters in his first interview with international media since stepping down last month after 10 years as the RBNZ's chairman.

New Zealand was the first country to adopt an inflation target as its main central bank policy goal, and in the late 1980s and 1990s undertook other reforms that later found favour elsewhere around the world - including forward guidance on monetary policy.

Grimes said investors were still likely to pile into asset price bubbles because they expected that even if they burst, central bank action to support the economy would soon cause asset prices to return to their previous levels.

The U.S. Federal Reserve was particularly at fault after repeatedly supporting markets following brief episodes of financial market turmoil from the 1980s onwards, Grimes said.

"In my view it was a big mistake by the Federal Reserve," he said, adding that the underlying cause was the Fed's dual mandate of targeting unemployment as well as inflation.

"They are stuck between a rock and a hard place, in terms of the Fed officials themselves. You would have to have a big bang to say: 'We are targeting price stability. We are targeting stable asset prices as well as stable goods prices.'"

YELLEN 'TERRIFIC ACADEMIC'

Grimes praised Janet Yellen, the newly announced nominee to succeed Fed Chairman Ben Bernanke, as "a terrific academic economist", but declined to speculate on whether she would lead the U.S. central bank in the direction he would prefer.

Such a change would need new legislation and potentially require the United States to tolerate high unemployment after a future asset price bubble burst - something Grimes likened to the battle many countries faced to bring down high consumer price inflation in the 1980s and 1990s.

Grimes also had words of caution for central banks adopting forward guidance on their future interest rates, saying it needed to be consistent and should not be a mask for changing inflation goals.

"If you revise based on new information, that is fine. If (the public) think you are going to revise your criteria for where you are going, then you lose your credibility," he said.

The Fed and the Bank of England have both adopted guidance which links rises in interest rates to unemployment falling to a certain level - a different model to the RBNZ's, which produces a forecast for the level of its interest rates.

The Bank has said it will not raise interest rates before unemployment falls to 7 percent, unless inflation threatens to get out of control.

But it has said the 7 percent level will not be a trigger for higher rates, leaving open the possibility that this threshold could be revised lower if there seems to be greater slack in Britain's economy.

(Editing by Hugh Lawson)