Thesis: On the optimal response for monetary policy when on the ZLB, fiscal policy is constrained in boosting aggregate demand, because of the Fed’s 2% inflation target, and thus in order to for it to work effectively, it would require a ‘regime shift’ to price level targeting.
Summer closing nearer, labor market conditions improving, household purchasing power has increased due to the decline in commodity prices, it won’t be long before interest rates are on the rise and the ZLB becomes a thing of the past, at least for America. David Beckworth seems to agree that as the U.S economy improves, the ZLB debate will become moot. Nonetheless, it is important to keep the ZLB debate in mind, since we still don’t have a consensus amongst economists for the best way to conduct monetary policy at the ZLB. David Beckworth write’s in response to Ben Bernanke on the future of Monetary policy, where Bernanke suggests:
A possible direction of change for the monetary policy framework would be to keep the targets-based approach that I favor, but to change the target. Suggestions that have been made include raising the inflation target, targeting the price level, or targeting some function of nominal GDP… a principal motivation that proponents offer for changing the monetary policy target is to deal more effectively with the zero lower bound on interest rates. But economically, it would be preferable to have more proactive fiscal policies and a more balanced monetary-fiscal mix when interest rates are close to zero. Greater reliance on fiscal policy would probably give better results, and would certainly be easier to explain, than changing the target for monetary policy.
Bernanke takes a stance that a monetary-fiscal mix would’ve been preferable in generating greater aggregate demand over the past six years. However Beckworth argues that fiscal policy is limited by its ability to boost aggregate demand, because of the Fed’s 2% target inflation rate. This is interesting because part of Bernanke’s blog post, suggests that tinkering with the 2% inflation target for future monetary policy would be costly, mainly because monetary policy since the Great Moderation has anchored inflation expectations at 2%, thus changing the level of inflation target would take time in establishing long-term credibility in order to deviate from the history we have had with 2% inflation targeting. Although Bernanke suggests that the monetary-fiscal mix would be optimal, he acknowledges that “the probability of getting Congress to accept larger automatic stabilizers.. is low.”
Beckworth demonstrates with an example, that for fiscal policy to have worked in reducing the output gap over the past 6 years, we would’ve needed a monetary policy ‘regime shift’ to price level targeting. In his example, the regime shift would require the price level target to bring back the PCE to its pre-crisis trend path. In order to bring the PCE back to trend, this would require temporary high periods of inflation. This inflation burst “would be the catalyst that spurred robust aggregate demand growth.”
Further in the example we assume the Fed has made QE2 conditional on the PCE returning to its 2002-2008 trend path. In the graph below, we see three different paths for the price level target which are highlighted as three rates for catch-up inflation, 3%, 4%, and a 5%. We see that greater levels of inflation reduce the amount of time it takes to catch up to the previous PCE trend.
So in order to get robust aggregate demand growth there needs to be a temporary period of higher inflation. However with the Fed’s 2% inflation target, this would be infeasible, hence rendering fiscal policy ineffective if it is only able to benefit the economy upon reaching the 2% cap on inflation. This topic is good for discussion because it is an example of why fiscal policy may not be very effective during times of economic turmoil. We see the downsides of anchoring inflation at 2% since we limit the alternative methods for a robust recovery, but although probably unlikely, a regime shift could have resulted in robust recovery during the great recession.