Raising the Inflation Target Rate to Evade the Zero Lower Bound

The discussion of whether the Federal Reserve should raise the federal funds rate is a highly contentious one. Members of the Federal Reserve (“Fed”) and academic economists disagree about what constitutes appropriate future macroeconomic policy for the Unites States. In the past, the Fed had been able to raise rates when the unemployment rate was under 5% and inflation was at a target of 2%. Enigmatically, since the Great Recession and despite a strengthening economy, year-over-year total inflation since 2008 has averaged only 1.4%—as measured by the Personal Consumption Expenditures Price Index (“PCE”). Today, PCE inflation is at 1-1.5% and has continuously undershot the Fed’s inflation target of 2% three years in a row. (Evan 2015) In the six years since the bottom of the Great Recession the U.S. economy has made great strides in lowering the published unemployment rate from about 10% back down to about 5.5%. In light of this data, certain individuals believe that the Federal Reserve should move to increase the federal funds rate in 2015 because unemployment is near 5% and inflation should bounce back on its own (Derby 2015). However, this recommendation is misguided.

It widely recognized that the monetary policy within a country should be primarily concerned with the pursuit of price stability. However, it is still not clear how this objective can be achieved most effectively. This debate remains unsettled, but an increasing number of countries have adopted inflation targeting as their monetary policy framework. (Dr E J van der Merwe, 2002) This topic of Inflation targeting is a subject which immediately conjures different perceptions from different people. Many feel that low inflation should be a main aim of monetary policy, while others (such as trade union activists) believe that a higher growth rate to stimulate jobs should be the main concern.

One of the most consistent defenses against deflation is for a central bank to target an inflation rate greater than zero. The Federal Reserve’s current inflation target is 2% and has informally been at that rate for quite some time. This nonzero target provides a cushion for policymakers: should inflation decrease due to an unexpected shock to aggregate demand, prices should not immediately start falling. This allows policymakers to act with easy money when inflation reaches 1 or 0%, thus avoiding deflation. Yet, during the last two recessions in the United States, the 2% inflation rate did not prevent significant fear of deflation. Extraordinary action was required, and many economists argue that the low interest rate policy following the 2001-2002 recession contributed to the housing bubble that was inflating at that time. It is not yet known what the impact will be from the unorthodox policies taken in response to deflation fears in 2009-2010. Based on these experiences, it may be time to consider alternative inflation targets to provide greater insulation from deflationary pressures.

First I am going to talk about the Fed’s “dual mandate”. What is the dual mandate? Congress amended The Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as, ”The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” (Chicago Fed 1). It if often called the "dual mandate" and guides the Fed's decision-making in conducting monetary policy. Now I am going to talk about the tools that the Fed use’s to achieve its goals. Some goals consist of a low unemployment rate, a stable price level, and economic growth. To help complete these goals the Fed uses certain tools to help fulfill them. An example would be a monetary policy that helps to close a recessionary gap and thus promotes full employment may accelerate inflation. A monetary policy that seeks to reduce inflation may increase unemployment and weaken economic growth. The Fed undertakes stimulative measures in response to a recessionary gap or even in response to the possibility of a growth shutdown to not allow the high inflation rates of the 1970s to occur again. Now I am going to explain what happens when the Fed pursues an expansionary or contractionary policy. “Expansionary policy, such as a purchase of government securities by the Fed, tends to push bond prices up and interest rates down, increasing investment and aggregate demand. Contractionary policy, such as a sale of government securities by the Fed, pushes bond prices down, interest rates up, investment down, and aggregate demand shifts to the left,” (Saylor

“FOMC began to raise the target federal funds rate in June 2004. This guidance was designed to influence asset prices, economic activity, and inflation in a manner consistent with the goals of price stability and full employment. “(2)

Therefore, the quantitative easing adopted from 2009 was trying to gradually resume sustainable economic growth. Quantitative easing has helped to avert what could have been a second great depression (Wall Street, 2011). The US economy has been clawing its way out of the recession in 2009 and recovery has been slow compared to previous economic cycles. Regular review of the pace of securities purchase by the Federal reserve and the overall size of asset-purchase program in light of incoming information and adjusting the program as need be will help foster maximum employment and price stability.

Japan saw its nation change in 1990 when the Japanese economy stagnated. Indeed, between 1991 and 2003 the Japanese economy only grew 1.14% (of GDP) every year. This is not enough when compared to other developed countries. (Yuji Horioka, 2006). Alexander, A. J. (2000) states the facts that from the first quarter of 1990 to the first quarter of 2000 the annual increase in real gross domestic product per capita barely exceeded 1 percent, making it very clear that Japan was in a recession. This is all the

The weaker-than-expected Employment Situation report for August was generally pleasing news for financial markets. Importantly, it seemed to confirm the continuation a slow growth economic equilibrium, characterised by low levels of unemployment and inflation. The short-term implication for financial markets is that the report makes it highly unlikely that the Federal Open Market Committee (FOMC) will embrace a more hawkish posture. Meanwhile, any continuation of similar reports in subsequent months will raise the ante between those FOMC members who are concerned about low inflation and those who fret about potential financial instability.

The July FOMC minutes [http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20150729.pdf] first raised doubts about this view, highlighting how the recovery might be incomplete, due to slowing global growth, while financial conditions have tightened due to the China-led equity sell-off. At that meeting, almost all members would need more evidence to be reasonably confident in the inflation outlook’s improvement.

In the past two decades, a multitude of countries, including Canada and Australia have instituted “explicit inflation targeting” (Svensson, 1996, p.1) for fear of the high cost of “volatile inflation” (Freedman&Laxton, 2009, p. 6).Mishkin offered the definition of inflation targeting (IT). It is a monetary policy strategy intended to achieve price stability within a specific range (Mishkin,2000).As is concisely demonstrated by Mishkin, IT “establishes a transparent and credible commitment” to the precision of the future “numerical objective”(Mishkin,2008).Nonetheless, it is not a prudential policy. It is prone to encounter the predicament of “long and variable lags” of “implementing and monitoring” the policy (Svensson,

Weak productivity and slow growth in the labour force have combined to reduce the long-term sustainable growth rate of the US economy. Under normal circumstances, this would prompt a hawkish policy stance from the Fed. It appears that any remaining disputes all boil down to the issue of how to measure productivity, particularly the gains stemming from the use of information technology and software. This debate is, however, hardly new, dating back to the late-1990s. Fed Chair Yellen appears to be taking the lacklustre productivity readings at face value. Over the course of a business cycle, the growth of real wages and productivity has typically moved in tandem. Thus, the post-Great Recession period of weak real wage expansion is, in Fed Chair Yellen’s view, simply a reflection of poor expansion in output per hours worked. How might the Fed react? The events of the late-1990s may provide a useful framework for the FOMC. Real wages do not automatically adjust to changes in productivity. The surge in technological innovations between 1995 and 2000 had a big impact in boosting productivity, but workers’ compensation failed to keep pace. The sluggish adjustment in wages had important ramifications for US monetary policy conduct. Former Fed Chairman Greenspan termed the combination of low wage inflation and higher-than-expected productivity growth

Quantitative Easing is defined as the expansion of Central Bank Balance sheet (Bernanke and Reinhart 2004) in order to stimulate the economy via the purchase assets financed by the creation of central bank reserves, such as government bonds, T-bills and mortgage and exchanging for reserves, since the bank rate has been reduced below the effective level, for instance, Bank of England has cut its bank rate in a sequence of steps from 5% in October 2008 to 0.5% in March 2009 and further to 0.25% recently. The Central Bank usually proceed the asset purchase via increasing the reserves of commercial banks held in the account of Central bank, leading to an increase in deposit in the balance sheet of commercial banks. However, on the liabilities side, nothing has changes and in order to match up, the commercial banks will purchase more long-term assets both because the current asset side has mainly composited of short-term assets and because the large purchase has increased the price of government bonds (Bank of England prefers to implement QE via large purchase in government bonds), leading to relative lower price for other assets; as a result, commercial banks will buy other long-term assets, lowering the yields of those assets. As long as, thus, money is not a perfect substitute for assets sold, banks or sellers, more general, may tend to purchase other asset that are better substitutes in order to balance their portfolios, known as the portfolio substitute channel. In addition,

Oil is used in the production of many goods and services and countries dependant on oil would face cost push inflation which is denoted by an upwards shift of the AS curve in Figure 5 from to as shown in the figure below. We see that prices have increased from to and we will have a negative output gap as output has decreased from to . If the Central Bank is forced to set inflation as low as possible, they could go about it by reducing aggregate demand from to but output has to fall even further to . The cost to output and employment by forcing a low inflation is greater when it comes from a supply shock, and this already assumes that the Central Bank knows perfectly what is happening in the economy. In the past, the Federal Reserve placed a greater priority on reducing the output gap and unemployment and they eased its monetary policy in response to these oil shocks (Clarida, Gal´ı, and Gertler, 2000) . Once again, the trade-off between employment and inflation is highlighted, as they were willing to accept a much higher level of inflation while placing a greater emphasis on other macroeconomic priorities. Yet, if the Central Bank is forced to set inflation to as low as possible, we will have to tolerate a very high (negative) output gap, unless they are able to use other methods to reduce inflation, which will be discussed later in this essay.

It widely recognized that the monetary policy within a country should be primarily concerned with the pursuit of price stability. However, it is still not clear how this objective can be achieved most effectively. This debate remains unsettled, but an increasing number of countries have adopted inflation targeting as their monetary policy framework. (Dr E J van der Merwe, 2002) This topic of Inflation targeting is a subject which immediately conjures different perceptions from different people. Many feel that low inflation should be a main aim of monetary policy, while others (such as trade union activists) believe that a higher growth rate to stimulate jobs should be the main concern.

Central banks were not entirely unprepared for this challenge. In the 1990s the Japanese economy had slumped following an asset-price crash. Facing weak growth and deflation the Bank of Japan had slashed rates to near-zero before embarking on a series of experiments with unconventional monetary tools. Although the Bank of Japan’s performance was widely considered disappointing, if not an outright failure, the rich world’s central banks began by drawing upon its playbook.