A Call for Action: Conditional Inflation Targetting

From an article by myself and Jeffry Frieden in the newly released Foreign Policy: We need
...inflation -- just enough to reduce the debt burden to more manageable levels, which probably means in the 4 to 6 percent range for several years. The Fed could accomplish this by adopting a flexible inflation target, one pegged to the rate of unemployment. Chicago Fed President Charles Evans has proposed something very similar, a policy that would keep the Fed funds rate near zero and supplemented with other quantitative measures as long as unemployment remained above 7 percent or inflation stayed below 3 percent. Making the unemployment target explicit would also serve to constrain inflationary expectations: As the unemployment rate fell, the inflation target would fall with it.

Today our highest priority should be to stimulate investment, growth, and employment. Raising the expected inflation rate will lower real interest rates and spur investment and consumption. It will also make it difficult for the de facto dollar peggers, such as China, to sustain their policies. The resulting real depreciation of the dollar would stimulate production of U.S. exports and domestic goods that compete with imports, boosting American production. The United States would get faster growth, an accelerated process of deleveraging, a quicker recovery, and a firmer foundation upon which to address long-term fiscal problems.

We believe a similar policy regime is necessary for the euro area. Figure 1 highlights the distance we still need to go in the US to achieve a level of leverage consistent with resumed consumption growth.

Figure 1: "At current speed of de-leveraging we will reach pre-bubble level of debt/income in 2013" from Torsten Slok, "US Consumer Deleveraging: More adjustment needed," Deutsche Bank, December 2011.

This proposal follows from the conclusions we made in Lost Decades:

Americans face serious economic challenges. They lost the first
decade of the century to a boom that enriched the wealthiest, and
a subsequent bust that impoverished the rest. Now they risk losing
another decade to an incomplete recovery and economic stagnation.
None of the changes necessary to avoid a repeat of this disaster
will be easy. At every turn there are major political obstacles. Financial
interests resist regulations that shift the burden of risky behavior
back onto them and off of taxpayers. Beneficiaries of government
programs fight against attempts to curb their benefits. Taxpayers
refuse to pay the taxes needed to pay for the programs they want.
Partisan politicians block reasoned discussion, suggesting absurd
pseudo-solutions instead of realistic alternatives. Ideologues and
political opportunists encourage Americans to cling to the childish
things that have served them so poorly in the past: a mindless
belief that markets are perfect, that tax cuts solve every ill, that borrowing
is to be encouraged. Despite the great trouble these policies
have caused, their attractions continue to be touted and spouted by
unprincipled pundits.

Of these childish things is an unwarranted fear of inflation.

Figure 4: Implied inflation calculated as difference between constant maturity TIPS yields on five year Treasurys (blue), seven year (chartreuse), and ten year (red). Observations for December apply to December 28th observation. Source: St. Louis Fed FRED, and author’s calculations.