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An Inflation Target to Offset Deflation



Some commentators have begun suggesting that the Federal Reserve should announce an inflation target now, with the idea that it will prevent inflation arising from the coming massive fiscal stimulus. In my opinion, it couldn't hurt. As I argued with respect to Japan in 1998 , or as Ben S. Bernanke, Frederic S. Mishkin, and I argued with respect to inflation targeting in general in 1999, the point of inflation targeting is to anchor expectations at a stable low level—and it is at least as important to anchor them above zero against deflation as it is to keep them low in the future. Certainly, the Fed's aggressive attempts to forestall severe recession can only be helped by such an announcement.

We should not, however, expect too much impact from announcing an inflation target now. In fact, we should not expect much impact on the economy from any of the "unorthodox" monetary measures being undertaken by the Fed at present: some alleviation of lock-ups in particular markets with targeted interventions, as in commercial paper, yes; but broader impact on the course of the economy and inflation expectations, no. The declining inflation expectations and reluctance to invest or lend are being driven by "animal spirits" and asset market developments, which monetary policy is not really going to be able to affect much.

If such an inflation target is announced, and it is combined with a commitment not to raise interest rates until some positive inflation target level is reached (as the Bank of Japan finally committed in 2003), it would be more likely to have a beneficial effect. There is good reason, though, why the baton has been passed to fiscal policy right now. Monetary policy has been applied in full and is now relatively ineffective. The most important thing that the Fed can do, which it is already doing, is to be as supportive as possible of the stimulus and the associated debt to be issued. An inflation target is about anchoring inflation to the upside here, not preventing future inflation.

Will the use of the Fed’s vaunted printing press to support fiscal policy cause future inflation? In the spirit of "it couldn't hurt," I would say: "We should be so lucky."

Japan printed an enormous amount of money and issued a huge amount of public debt between 1995 and 2005, and barely emerged from deflation briefly only to fall back into it recently. Mechanistic monetarism has no empirical support, especially in such a context of deflationary pressures and negative demand growth. Yes, I was worried about inflation last summer, when I underestimated severely the decline in growth that we now are experiencing. Now that it is clear that growth will be well below potential for a while, I have no worries about inflation. And during a global downturn in which there will be no massive depreciation of the dollar—if anything probably an appreciation when the United States returns to growth sooner than most other economies—I worry even less about inflation.

Sure, sustained fiscal indiscipline would eventually lead to inflation. That just says that the emphasis on constraining inflationary pressures from fiscal policy has to rest with fiscal policy itself. So the Treasury could issue more inflation-indexed debt. More importantly, I think the Obama stimulus proposals could be accompanied by explicit commitments to the following:

  • Spending for stimulus all being temporary—no new ongoing programs;
  • Raising taxes (ideally on carbon—I have a dream) in the near future;
  • Funding the new stimulus with short-term debt so that any decision to roll it over has to be confronted soon;
  • Reforming social security/health insurance while expanding coverage;
  • Using the purchase of bad assets from the banks to provide some upside potential for taxpayers.

So, yes, an inflation target, but not as a bulwark against future inflation. Announce an inflation target as an additional attempt to keep inflation expectations positive. Rising inflation is the least of our worries right now.

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