The Fed should announce an inflation target, and it should be a fairly high target

[Kurt_and_Hunter]

In reference to what could be done to help the economy that would not have to pass Congress...

"Krugman (1999) and others have suggested that the Fed quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the Fed is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by years of zero or negative inflation.

Fed officials have strongly resisted the suggestion of installing an explicit inflation target. Their often-stated concern is that announcing a target that they are not sure they know how to achieve will endanger the Fed’s credibility; and they have expressed skepticism that simple announcements can have any effects on expectations.

With respect to the issue of inflation targets and Fed credibility, I do not see how credibility can be harmed by straightforward and honest dialogue of policymakers with the public. In stating an inflation target of, say, 3-4%, the Fed would be giving the public information about its objectives, and hence the direction in which it will attempt to move the economy. (And, as I will argue, the Fed does have tools to move the economy.) But if Fed officials feel that, for technical reasons, when and whether they will attain the announced target is uncertain, they could explain those points to the public as well. Better that the public knows that the Fed is doing all it can to reflate the economy, and that it understands why the Bank is taking the actions it does. The alternative is that the private sector be left to its doubts about the willingness or competence of the Fed to help the macroeconomic situation."

http://www.princeton.edu/~pkrugman/bernanke_paralysis.pdf

The preceding is a brilliant explanation of what the Fed should be doing today. It was written by Ben Bernanke in 1999 in a paper entitled "Japanese Monetary Policy: A Case of Self-Induced Paralysis?" All the references to the Fed above actually said "Bank of Japan" in Bernake's paper.

The word "co-option" comes to mind...


More discussion/info:
http://krugman.blogs.nytimes.com/2010/08/09/self-induced-paralysis/

[customerserviceguy]

1. Hmmm, interesting

First, the idea that 3-4% is high. Given the rates seen in my lifetime, I'd consider 7-10% high. 3% is almost insignificant inflation, historically speaking.

Second, while inflation is a jim-dandy way to pay off debt, it has other costs. It tends to make interest rates rise, using the rate of inflation as a floor. That's fine if you plan to raise taxes, cut spending, and pay off the national debt, but if you don't, it just increases your costs. Also, inflation is permanently factored into the Social Security cost of living increases, and as you have the very first baby boomers reaching 65 in less than five months, it's not all that desirable over the next thirty-five years before that generation dies off in significant numbers.

[Kurt_and_Hunter]

2. The point about expectations is to keep money cheap...

The point of the Fed setting a "high" (I agree with you... 4% is not scaring me conceptually) inflation target is that the target is an effective promise that the Fed will not raise rates unless inflation goes over 4%.

And that gets money off the sidelines.

The problem is that with Fed Fuds rate at 0% the Fed cannot do anything directly to make borrowing cheaper... they are out of bullets.

But the real cost of borrowing is nominal interest rates minus inflation.

Since the Fed cannot cut rates below 0% they need to create some inflation while keeping money cheap. That works out the same as an interest rate cut.

It is said that if rates hadn't hit 0% the Fed would have gone another 5-6% during the collapse... essentially, to negative 6% interest.

We cannot do that, but we can approximate it by changing the other side of the real borrowing cost equation.

(The original Krugman paper this is all about is full of economist squiggles but I can read the English part with moderate comprehension: http://web.mit.edu/krugman/www/bpea_jp.pdf )