July 15 (Bloomberg) -- Pacific Investment Management Co.’s Paul McCulley said the Federal Reserve should push inflation above its long-term target to coax consumers to spend money if the U.S. economy stays mired in recession.

“The way to make monetary policy effective is for the central bank to promise to be irresponsible,” McCulley wrote in a July commentary posted to Pimco’s Web site, citing a 1998 paper written by Princeton University economist Paul Krugman.

“Radically” different central-bank policy may be needed to change inflation expectations if the U.S. economy starts to resemble Japan’s era of deflation, McCulley wrote. He said the U.S. economy is not currently suffering from deflation. In addition to Krugman’s paper, McCulley cited a May 2003 speech by Fed Chairman Ben S. Bernanke as a blueprint for policy.

McCulley and his colleagues at Newport Beach, California- based Pimco, the world’s largest bond fund manager, have forecast a “new normal” in the global economy that will include heightened government regulation, lower consumption and slower growth. The U.S. government may need to enact a second stimulus plan to spur growth in the coming months, McCulley said July 7 in an interview with Bloomberg Radio.

If consumers and businesses continue to hoard cash, monetary policy makers may need to boost inflation until prices are as high as they would have been without deflation, McCulley wrote.

Undoing Deflation

“The inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone,” McCulley wrote. Only then should policy makers return to focusing on a long-term inflation target, he said.

Fed officials project inflation as measured by personal consumption expenditure to be in a range of 1.5 percent to 2 percent “over the longer-term” in the years after 2011, according to the projections released April 29.

Prices paid to U.S. producers rose in June by twice as much as anticipated, led by surging gasoline costs, a Labor Department report showed yesterday. The 1.8 percent increase in prices paid to factories, farmers and other producers followed a 0.2 percent gain in May, the department said. Excluding food and fuel, so-called core prices rose 0.5 percent.

Tepid consumer spending and business investment are forcing companies to boost incentives or keep a lid on prices in order to move merchandise.

McCulley, 52, heads Pimco’s short-term bond desk. He joined Pimco in 1999 from UBS Warburg, where he was the chief economist for the Americas.

Between 1996 and 1998, McCulley was named six times as a member of the Institutional Investor All-America Fixed Income Research Team. He has an undergraduate degree from Grinnell College in Iowa and an MBA from Columbia University in New York.

To contact the reporter on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net

Last Updated: July 15, 2009 08:02 EDT