Inflationary Expectations

Here’s Paul Krugman in 1998 making the case for an effort to create inflationary expectations:

Let us now bring this discussion back to earth, and to Japan in particular. Of course the Bank of Japan does not announce whether its changes in the monetary base are permanent or temporary. But we may argue that private actors view its actions as temporary, because they believe that the central bank is committed to price stability as a long-run goal. And that is why monetary policy is ineffective! Japan has been unable to get its economy moving precisely because the market regards the central bank as being responsible, and expects it to rein in the money supply if the price level starts to rise.

The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible — to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.

This sounds funny as well as perverse. Bear in mind, however, that the basic premise — that even a zero nominal interest rate is not enough to produce sufficient aggregate demand — is not hypothetical: it is a simple fact about Japan right now. Unless one can make a convincing case that structural reform or fiscal expansion will provide the necessary demand, the only way to expand the economy is to reduce the real interest rate; and the only way to do that is to create expectations of inflation.


It seems to me that central banks, as institutions, value their reputations as credible inflation fighters. The fact that such a reputation has benefits for central banks — or is perceived as having benefits — could lead to poor policy in situations of severe recession. Certainly the European Central Bank, which is right now probably the most important central bank in the world, has made it very clear that it regards maintaining a low level of inflation as its top priority. And the Bank of Japan was put to the test over this issue and clearly chose not to take this path. The Fed in the United States has never been as clear, but certainly shows no sign of taking this advice and trying to create inflationary expectations.