These rare occasions of liquidity traps are very different from typical economic recessions. Consequently, they require a unique monetary policy response. Economic theory tells us that in such circumstances monetary policy should aim to lower the real, or inflation-adjusted, rate of interest by temporarily allowing inflation to rise above its long-run path. My preferred way of doing so is to implement an approach called price-level targeting. Simply stated, under this approach, the central bank strives to hit a particular price-level path within a reasonable period of time. For example, if the rate of change of the price-path is 2 percent and inflation has been under-running the path for some time, monetary policy would strive to “catch-up” so that inflation would be higher than the inflation target for a time until the path was regained. This higher inflation rate would decrease the real interest rate, raising the opportunity cost of holding money. This would provide an incentive for banks and corporations to release funds for investment, and in the process spur job creation.

In my opinion, such a strategy is entirely appropriate.

I am also open to a move that I believe would strengthen the effect and compensate for potential risks of the policy action—that move is the adoption of a more explicit inflation objective by the committee. I believe doing so might serve as a further step to ensure the anchoring of public expectations about long-term inflation and the response of the FOMC to adverse price developments. I consider a more explicit inflation target as something the public could easily understand, and I believe it would reduce uncertainty at a time when it is badly needed.

The Federal Reserve has a statutory mandate to foster maximum employment and price stability, and explaining how we are working toward those goals plays a crucial role in our monetary policy strategy. It is evident that neither of our dual objectives can be taken in isolation...

Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate. The longer-run sustainable rate of unemployment is the rate of unemployment that the economy can maintain without generating upward or downward pressure on inflation...  Similarly, the mandate-consistent inflation rate--the inflation rate that best promotes our dual objectives in the long run--is not necessarily zero; indeed, Committee participants have generally judged that a modestly positive inflation rate over the longer run is most consistent with the dual mandate. (The view that policy should aim for an inflation rate modestly above zero is shared by virtually all central banks around the world.)...  Several rationales can be provided for this judgment, including upward biases in the measurement of inflation. A rationale that is particularly relevant today is that maintaining an "inflation buffer" (that is, an average inflation rate greater than zero) allows for a somewhat higher average level of nominal interest rates, which in turn gives the Federal Reserve greater latitude to reduce the target federal funds rate when needed to stimulate increased economic activity and employment.

[I]nflation is now on target, as far as I'm concerned. Over the last 12 months the price index for personal consumption expenditure has risen 1.5 percent, which is exactly what I've been recommending for the last six years. We also track a core price index that omits volatile food and energy prices, and it is sending the same message, having risen by 1.4 percent over the last 12 months. I believe that the Fed's best contribution to our nation's economic prosperity over time would be to keep inflation stable near the current 1.5 percent rate. But inflation has been lower this year, with overall inflation increasing at only a 0.7 percent annual rate, which is too low for me. I would point out that these inflation numbers often run hot or cold for several months at a time, which is why economists focus on the 12-month number I cited a moment ago. I am not yet convinced that inflation is likely to remain undesirably low. Moreover, the public's expectation of future inflation is not at such a low level; indeed, the latest survey from the University of Michigan puts the public's short-run inflation expectation at 2.2 percent. So I do not see a material risk of deflation — that is, an outright decline in the price level.

If we were to go down this path, it would be important to note that any provision of more information on our inflation objective would not be a signal that the inflation element of the dual mandate had become more important than the full employment objective. Instead, it would principally reflect the fact that inflation being “too low” (just like inflation being “too high”) is an impediment to achieving the full employment objective of the dual mandate.

If we judged it desirable, we could go still further and provide more guidance on how monetary policy would react to deviations from any stated inflation objective. One possibility would be to keep track of inflation shortfalls when the federal funds rate is constrained by the zero bound, as is the case today. For example, if inflation in 2011 were a 0.5 percentage point below the Fed’s inflation objective, the Fed might aim to offset this miss by an additional 0.5 percentage point rise in the price level in future years.

In the current environment, such an approach would have some advantages as well as some disadvantages. When there is a large amount of slack in the economy, the Federal Reserve might not easily be able to hit an inflation objective soon. But, the central bank could plausibly promise to make up the difference later on. Indeed, the further the Fed fell behind its inflation objective in the near term, the more inflation would need to increase in order to push the actual path of prices up to the path consistent with price stability over the long run. To the extent this policy was more credible, it might do a better job keeping inflation expectations from falling. This might make monetary policy more stimulative and, thus, might help the FOMC achieve its objectives more quickly.

 Having a single mandate for price stability, like the ECB’s, can make it easier for central banks to make credible policy commitments. Inflation targeting is another way to increase the credibility of monetary policy. Articulating an explicit inflation target and committing to keeping inflation near that target over some specified time period is a form of pre-commitment.

      Well, his {Laurence Ball} argument is that at a higher inflation rate, then nominal interest rates would also be higher, on average, and that would give more space to cut during a recession, and perhaps more ability to create impetus.

      So that's not a logical argument, but it has substantial risks which are -- you know, we, the Federal Reserve, over a long period of time, has established a great deal of credibility in terms of keeping inflation low, around 2 percent, roughly speaking. And you can see that, for example, in inflation-indexed Treasury debt, which shows that people expect, over the next 10 years, about 2.2 percent inflation, on average, over that 10-year period. 

      If we were to go to 4 percent -- and, say, we're going to 4 percent, you know, we would risk, I think, losing a lot of that hard- won credibility, because folks would say, 'Well, if we go to 4, why not go to 6;' and you go to 6, 'why not go to 8?' It'd be very difficult to tie down, credibly, expectations at 4, beyond which, of course, in the longer-term low inflation is good for the economy, and 4 percent is already getting up there a bit, and would probably have detrimental effects on the functioning of our markets, and so on. 

      So I understand the argument, but that's not a way -- that's not a direction that we're interested in pursuing. We're going to keep our inflation objectives about where they are. We think about 2 percent is about appropriate, given biases and measurement of inflation, and given the need to have a little bit of space between the average inflation rate and the risk of having deflation or falling prices. So that's where we're going to be -- that's the path we're going to be following. 

Some suggest that central bankers themselves should choose to modify their definitions of price stability. If inflation persisted at higher levels during normal times, the theory goes, central bankers could cut rates more substantially in response to economic weakness. The theory, in my view, fails the real test of experience.

Central banks that desire just a little more inflation may well end up with a lot more. Some point to a strategy to accept a little more inflation for less unemployment as a primary basis for the great inflation of the 1970s in the United States.¹⁰ By definition, an increase in an implicit inflation target would lead to an upward shift in inflation expectations. And how would a central bank make credible its promise that such a shift would be only a one-time event?

Recently, some prominent economists have called for central banks to raise their inflation targets to about 4 percent...

Although I agree that hitting the zero bound presents challenges to monetary policy, I do not believe central banks should raise their inflation targets. Central banks around the world have been working for 30 years to get inflation down to levels where it can largely be ignored by businesses and households when making decisions about the future. Moreover, inflation expectations are well anchored at those low levels.

Increasing our inflation targets could result in more-variable inflation and worse economic outcomes over time. First of all, inflation expectations would necessarily have to become unanchored as inflation moved up. I doubt households and businesses would immediately adjust their expectations up to the new targets and that expectations would then be well anchored at the new higher levels. Instead, I fear there could be a long learning process, just as there was as inflation trended down over recent decades. Second, 4 percent inflation may be higher than can be ignored, and businesses and households may take inflation more into account when writing contracts and making investments, increasing the odds that otherwise transitory inflation would become more persistent.

For both these reasons, raising the longer-term objective for inflation could make expectations more sensitive to recent realized inflation, to central bank actions, and to other economic conditions.

See also:  Greenspan 2002 and Mishkin 2008 for comments about effective price stability

Third, central banks need to be very careful in using information extracted from market data when conducting monetary policy. The anchoring of inflation expectations is a very important benchmark for assessing whether the stance of monetary policy has become too expansionary and whether there are risks of falling behind the curve. However, the pre-crisis period and the crisis itself have shown that expectations are not always formed in a rational way and might themselves be influenced by the behaviour of the monetary authorities. Quite often markets participants form their expectations by looking at central banks’ behaviour, on the assumption that the latter have better and more information about underlying inflationary pressures. Under these circumstances, market-based inflation forecasts tend to be biased and may react in a perverse way following a tightening of monetary policy. In particular, inflation expectations may be revised up, rather than down, after an interest rate increase, especially at the beginning of a tightening cycle. If the monetary authorities’ assumption that inflation expectations are well anchored proves to be wrong, the whole yield curve might move upwards and the decision to increase the rate of interest may result in a much sharper tightening than expected. ^[4]

Another problem with inflation expectations concerns their measurement, especially in periods of financial turbulence, when the liquidity of the underlying instruments can affect their signalling content. A further distortion may arise when the central bank is itself a major buyer and holder of indexed-linked assets, which may distort prices and thus the information content. Measurement problems arise also with other components of the analytical framework, such as the output gap. Experience shows that measurement of the output gap varies over time. For instance, when measured ex post, with the data available until 2008, the US output gap over the period 2002-2004 turned out to be very small, even non-existent, while ex ante it was estimated at around 2% of GDP. ^[5]

Editor's note:  We don't ordinarily include comments from central bankers in other countries in this database, but some comments are too insightful to pass up.

A credible inflation target would not only help prevent inflation expectations and actual inflation from rising to undesirable levels, but it would also help prevent expectations of deflation from materializing that could initiate an undesirable episode of falling prices.

“I don’t get it,” Volcker said, leading to a lively back and forth between the two central-bank heavyweights.

By setting 2% as an inflation objective, the Fed is “telling people in a generation they’re going to be losing half their purchasing power,” Volcker said. And if 2% is the best inflation rate, and the economic recovery lags, does that mean that 3% becomes the ideal rate, he asked.

Kohn responded that by aiming at 2%, “you have a little more room in nominal interest rates … to react to an adverse shock to the economy.”

“Your problem is two [percent] becomes three becomes four,” Kohn told Volcker. But other central banks with a roughly 2% target haven’t had that problem, Kohn said.

Fed officials, Kohn added, “need to be clear about why we’re choosing the number we’re choosing.” He also said that while he doesn’t think deflation is much of a risk, “I can’t say the risk is zero” and the Fed must be mindful of the possibility that inflation expectations fall to the point that real interest rates rise.

...

Kohn and Volcker fought to a rhetorical draw, with each conceding that he wasn’t going to persuade the other.

As reported by Wall Street Journal's Real Time Economics Blog.

Fortunately, I believe there is a way out of this dilemma: the Fed should adopt an explicit inflation objective and publicly commit to achieving that objective over some intermediate horizon. To me, the exact number or price index for the objective is somewhat less important than the public commitment to a goal. Such a commitment would help anchor expectations more firmly and diminish concerns of persistent inflation or persistent deflation — not an inconsequential issue in the current environment.

In addition to announcing an inflation objective, we must also clearly communicate our policy strategy to the public so that they understand how the FOMC anticipates achieving that goal. There are different ways to accomplish this. For example, Taylor-like rules that involve adjusting the federal funds rate in response to deviations of inflation from target and shocks to output or economic growth have some advantages. Such simple rules can be useful guides for conducting systematic policy and can help effectively communicate to the public the conditional nature of policy choices.

It seems to me that a change in the conduct of monetary policy following the experience of the 1970s has probably caused inflation expectations to become better anchored, explaining why recent oil shocks have inflicted relatively little damage on the economy. This hypothesis could at least partly explain why the huge run-up in energy prices through the middle of last year was not accompanied by rising wage demands. That in turn enabled the Fed to follow an easier monetary policy that gave greater weight to the output effect of rising oil prices than would have otherwise been possible.

Since mid-2008, oil prices have, of course, plummeted. But the extraordinary weakness in the economy means that the usual trade-offs associated with such supply shocks are absent right now. Any boost to spending from falling oil prices will be more than welcome in the current circumstances. And with inflation now below desirable levels, a decline in inflationary expectations that could push core inflation down over time would be most unwelcome. I argued earlier that the Fed’s inflation credibility helped over a number of years to keep inflationary expectations anchored in the face of rising oil prices and high headline inflation. My hope is that inflationary expectations will remain similarly well-anchored now, serving to stabilize core inflation. The FOMC’s recently released longer-run inflation projections should be useful in this regard, helping to reinforce inflation expectations of around 2 percent.

Currently, significant excess capacity in the economy risks lowering inflation and inflation expectations.  Since short-term interest rates are effectively zero, reductions in inflation expectations imply a higher real interest rate – and, effectively, tighter monetary policy.  So the additional clarity on the long-run intentions of monetary policy (as reflected in the longer-range forecasts) might keep inflation expectations well anchored[Footnote 4] and real interest rates low enough to help get the economy moving again. 

An important consideration involves what the long-run goal for inflation should be, given recent experience.  Twice this decade, short-term interest rates have approached zero, and the probability of possible deflation has risen significantly.  In light of this experience, some might conclude that the implicit inflation target has been too low.  A fruitful area for future research would be to re-consider the likelihood and the cost of hitting the zero lower bound, and what that cost implies for setting inflation targets.[Footnote 5]