Raising the Inflation Target Rate to Evade the Zero Lower Bound

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Raising the inflation target rate to evade the Zero Lower Bound | Econ 134 GSI: Yury Yatsynovich|
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Deepak Ravichandran|
4/17/2012|

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From its inception, the central bank’s onus has always been a dual mandate; to maintain maximum employment while at the same time keeping stable prices. While we as economists have learned much about the mechanism through which monetary policy affects the economy, much is still unknown about the inner workings of the economy, and the long-term effects of varying monetary policy. Over the past two decades, the Federal Reserve has dictated that the inflation target rate should be close to two percent for the American economy, yet this idea has come into question in the past 5 years. In these more recent times, the Federal Reserve has struggled to stimulate an economy that has been launched into a recession by a global financial crisis. Their normal practice of lowering the federal funds rate became ineffective as the nominal interest rate approached the Zero Lower Bound (ZLB). Monetary policy fell into the “liquidity trap”, with the Federal Reserve running out of room to lower the nominal interest rate through open-market operations. As a result of this situation, many leading economists, including Olivier Blanchard, head of the International Monetary Fund (IMF), clamored for an increase in the target inflation rate, from its historical level of two percent to four percent, in order to give the Federal Reserve more room to lower the federal funds rate (and thus the real interest rate) before it reaches the ZLB (Blanchard, 2010). This paper aims to evaluate the validity of this claim through its basis in economic history and research, and finally makes a recommendation as to its adoption. This will be done in a three-pronged approach, first looking at empirical case-study evidence presented by the Japanese ZLB crisis between 2001-2006, and supplementing this with economic research and models being done on the impact of the ZLB on the economy and its tradeoffs with higher inflation, and finally looking at criticisms of this approach and its ultimate viability. When looking for historical evidence of monetary policy at the Zero Lower Bound, an excellent case study is that of the Japanese Financial Crisis, between the times of 2001 and 2006, which provides insight into how the structure of monetary policy and the target inflation rate can factor into the ability of the central bank to respond to output gaps. In this case, the Japanese government began to follow a protocol of quantitative easing in 2001, as it had become clear that pushing interest rates down near zero for an extended period (mid 1990’s-2001) had failed to get the economy moving and led to deflation (Hayashi, 2010). After five years of gradually expanding its bond purchases, the bank dropped the effort in 2006, and at first, it appeared the program had succeeded in stabilizing the economy and halting the slide in prices, with inflation hovering at one percent. However deflation returned drastically over the next two years, proving the ineffectiveness of quantitative easing to stimulate economic growth and maintain inflation targets (price stability) at the ZLB. In the post-war era of the American economy, the Zero Lower Bound of the federal funds rate had never been reached until the current episode, and previous common thought was that it would not be reached in the American Economy and was an economic curiosity for Depression economists. However, as evidenced by the current recession, it is a cause for concern as traditional monetary policy rules such as the Taylor rule break down at the ZLB when the real interest rate cannot be lowered through open market operations. While unconventional monetary policy tools such as quantitative easing are possible at the ZLB, they are not as effective as traditional monetary policy tools in affecting interest rates. One of the main pitfalls of quantitative easing is...
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