Our target should simply be to keep the dollars value constant compared to a basket of goods. in the old days that was simply gold. That is a better bet than letting Greenspan "do his thing", but a basket of goods including gold might be more stable.

First, Inflation-Indexed bonds seem to me a clearly undervalued asset (against a background where nobody knows whether most assets have hit bottom or not).   Using the conventional break-even approach, TIPs imply an extremely low long-term US inflation rate.  That doesn't even take into account the asymmetric form of their indexation which makes them a one-way bet:   their nominal value rises if inflation is positive, but does not fall if inflation is negative.  Surely the market is not correctly pricing them.  One implication is that TIPs cannot be relied upon as an indicator of expected inflation.   Another is that we should all buy them.  (I think I have all that right.)   But I am not sure there is a better argument for the Fed buying these bonds rather than all the other assets they are buying.  Perhaps the Treasury should swap them for conventional Treasury bonds, thereby improving the long-term fiscal situation.   Regarding Inflation Targeting, it seems to me that this reigning monetary regime has taken two huge knocks over the last two years.     First, the universal choice of inflation targeters to focus on the CPI implies that the monetary response to an increase in the world price of oil and other commodity imports ( or to adverse supply shocks in general) is perverse:  if the rule to target the CPI is applied literally, it dictates a monetary tightening and currency appreciation in proportion to the magnitude of the increase in oil prices, which is exactly the wrong reaction to a deterioration in the terms of trade.  My proposal would be to focus on the PPI (or GDP deflator ) instead of the CPI, which is a more robust regime with respect to terms of trade shocks.   Secondly, most macroeconomists have now concluded that central banks should pay some attention to asset prices (stock prices and home prices), above and beyond any informational content they contain regarding inflation.  The Japanese bubble of the late 1980s strongly suggested this conclusion, and now the US asset bubble-and-crash have seconded the motion.   Having said all that, setting an inflation target might indeed be a good idea at the current conjuncture.   For one thing, the current problem in the economy is inadequate aggregate demand -- arising from the financial crisis, of course -- rather than adverse supply conditions.  For another, the special problems of a deflation threat can probably be appropriately addressed by setting a positive target

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It couldn't hurt.  As I argued with respect to Japan in 1998, or as Bernanke, 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 to keep them low in the future.  Certainly, the Fed's aggressive attempts to forestall severe recession that would not be impeded at all 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, like 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 effect much. 

IF such a target is announced, and was combined with a commitment not to raise interest rates until some inflation target level is reached (as the Bank of Japan finally did in 2003), it could have a beneficial effect, and wouldn't hurt.  There is good reason, though, why the baton has been passed to fiscal policy right now, with monetary policy 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 associated debt issuance.  An inflation target is about anchoring inflation to the upside here, not preventing future inflation.

Will such a use of the vaunted printing press 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 in 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 (which Lachman to his credit forecast correctly).  Now that it is clear that growth will be well below potential for a while, I have no worries about inflation.  And in a global downturn where there will be no massive depreciation of the dollar - if anything probably an appreciation when we return to growth sooner than most - I worry even less about inflation.

Sure, sustained fiscal indiscipline would eventually lead to inflation. That just says that the emphasis on constraining inflation 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 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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         With every indication that the US economy is now in the throes of its deepest post-war recession, Federal Reserve Chairman Ben Bernanke is right to be worried about the risk of price deflation. However, in embracing unorthodox policy measures to avert Japanese-style deflation, Mr. Bernanke should be very careful not to throw caution to the wind. For by indiscriminately resorting to the Federal Reserve’s printing press, he could all too easily compromise the country’s future growth prospects.

        In 2003, at the time of an earlier US deflation scare, Mr. Bernanke delivered his famous “helicopter” speech. In that speech, he emphasized that in principle the Federal Reserve’s printing press gave it plenty of ammunition to fight deflation even once interest rates had been reduced to zero. To graphically illustrate his point, he indicated that, as a last resort, the Federal Reserve could always drop dollars from a helicopter to revive spending in the economy.

        In his helicopter speech, Mr. Bernanke correctly identified two basic reasons why at all costs one needed to avoid allowing deflation to take hold. First, he noted that consistently falling prices would make it impossible for the Federal Reserve to reduce the real cost of borrowing once interest rates had been reduced to zero, as is pretty much the case today. Second, he observed that deflation would have the toxic effect of increasing the real burden of household and corporate debt. In today’s world, where US private debt has rapidly escalated to 290 percent of GDP, rising real debt burdens could very well result in mass insolvency and falling demand.

        With unemployment now rising at an alarming rate and with international oil prices collapsing, the deflation threat is again knocking at our door. Over the last three months, consumer prices have fallen at their fastest rate in the past sixty years. Meanwhile, the various measures of inflation expectations suggest that market participants now expect falling prices. This is most vividly illustrated by the fact that yields on the government’s inflation linked bonds (TIPS) suggest that markets are expecting that consumer price inflation, excluding food and energy, will decline by 5 percentage points over the next five years.

       By aggressively resorting to the printing press to finance large budget deficits and by indiscriminately lending to the private sector, the Federal Reserve certainly has the ammunition to beat deflation. However, moving in that direction runs the very real risk of compromising the country’s longer-term economic growth and employment prospects. It would do so through heightening the risk of a burst in inflation once an economic recovery were to get underway. It would also do so by facilitating the crowding out of future investment, by undermining the efficient functioning of the capital market, and by increasing the risk of a dollar crisis.

        Before Mr. Bernanke further resorts to the Federal Reserve’s printing press, he might want to consider that the major impediment right now to any economic recovery is not that interest rates on government paper are too high. It is rather that we have very deep problems in the US financial system that is inhibiting banks from lending. Despite the literally hundreds of billions of dollars in liquidity injections by the Federal Reserve, and despite the disbursement of around US$350 billion under the Troubled Asset Relief Program (TARP), the US financial system today is practically as dysfunctional as it has been at any time over the past eighteen months. The banks are not lending, the securitization process has all but dried up, and the interest rate spreads that even the best rated of corporations are paying have widened to highly onerous levels.


       One has to hope that amongst the very first priorities of the new US Administration will be a radical rethinking of the TARP program in an effort to restore the US financial system to a semblance of normality. One also has to hope that Mr. Bernanke supplements the historic steps that the Federal Reserve took last month toward quantitative easing by adopting two further measures to leave little doubt that the Fed is serious about combating deflation in a responsible manner. The first, which Mr. Bernanke himself proposed in his helicopter speech, would be for the Federal Reserve to provide the public with a quantitative working definition of price stability as a guide to forecasting the Fed’s future behavior. The second measure might be for the Fed to purchase government inflation linked bonds (TIPS) as the clearest of indications that the Fed truly believed that it would succeed in avoiding deflation.
 

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