Why aren’t we using monetary policy to stimulate aggregate demand?

My NYT column today is about why we can't move to a three percent inflation target (which I favor, at least for some number of years) and how we might make the leap.  Excerpt:

…if the Fed announces a commitment to a higher inflation target but fails to establish its credibility, it will have shown impotence. It would be a long time before the Fed was trusted again, and the Fed might even lose its (partial) political independence. All of a sudden, the Fed would end up “owning” the recession.

Part of the credibility problem stems from the political environment, especially in Congress. Imagine the day after the announcement of a plan for 3 percent inflation. Older people, creditors and workers on fixed incomes – all connected to powerful lobbies – would start to complain. Republicans would wonder whether they had found a new issue on which to campaign, namely, opposition to inflation. And Democrats would worry about what position to take. Presidents of some regional Fed banks would probably oppose the policy publicly.

…The Fed lost some of its political independence during the financial crisis. It undertook major rescue operations in conjunction with the Treasury, and these bailouts proved extremely unpopular. Congress has taken a closer look at Fed operating procedures and will engage in a one-time audit of the Fed’s emergency lending. When it comes to inflation, the Fed cannot easily turn to Congress and simply ask to be trusted.

This is the sad side story of our financial crisis: especially when it comes to financial matters, a great deal of trust has been lost. There is the prospect of a free lunch right before us, yet it is unclear that we will be able to grab it.

…In failing to push harder for monetary expansion, is Mr. Bernanke a wise and prudent guardian of the limited discretionary powers of the Fed? Or is he acting like a too-hesitant bureaucrat, afraid to fail and take the blame when he should be gunning for success?

A few points:

1. For reasons of space, I could not note that the so-called "robust Reagan recovery" had price inflation of over four percent a year.  Many conservatives shy away from recognizing this.

2. Three percent inflation also would help the currently impossible state of the real estate market, by lowering the real value of debts.

3. I do not mean to discriminate against Scott Sumner's nominal gdp idea, but it is easier to explain an inflation rate target to a public audience.  Here is my earlier column on Scott.

4. Maybe we are in a new political economy equilibrium where each government agency is given "one shot" at a problem.  Treasury had its one shot with the stimulus plan.  The Fed had its exotic monetary policy operations and deal-making during the crisis.  Maybe in bad times voters aren't happy no matter what, and no one is allowed to try twice.  We have not yet thought through the political economy of this scenario.

5. If the Fed can't make the commitment today, when did it go wrong?  Perhaps at the peak of the crisis, when it was operating with a high degree of discretion, and various radical actions were viewed as justified, it should have announced that, to complete recovery, the three percent price inflation commitment would commence after the dust had settled.  That would have required Magnus Carlsen-like levels of foresight, however.  If nothing else, Bernanke may not have realized that some version of #4 was operating.

6. Contra Mark Thoma, I am not so worried about time consistency problems, provided that Congress supports the Fed.  As long as the economy is weak, it's in the Fed's interest to keep up the three percent inflation.  If people know that in better times we will eventually settle back to two percent inflation, I don't think this undercuts the whole idea.

7. It remains instructive to read Bernanke's 1999 Japan piece, for instance:

BOJ 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 Bank’s credibility; and they have expressed skepticism that simple announcements can have any effects on expectations. On the issue of announcement effects, theory and practice suggest that “cheap talk” can in fact sometimes affect expectations, particularly when there is no conflict between what a “player” announces and that player’s incentives. The effect of the announcement of a sustained zero-interest-rate policy on the term structure in Japan is itself a perfect example of the potential power of announcement effects.

With respect to the issue of inflation targets and BOJ credibility, I do not see how credibility can be harmed by straightforward and honest dialogue of policymakers with the public.

Maybe I'm too Straussian or too Freudian here, but I read him as trying to promote the commitment, without being totally sure it is possible; note the "distancing" language at the critical points of the argument.  I believe Bernanke wrote this next part before he completely understood the incentives of bureaucracies to conserve information:

But if BOJ 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 BOJ 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 BOJ to help the macroeconomic situation.


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