Monetary Policy à La Krugman

Paul Krugman’s preferred monetary policy strategy:

What I’d do if I were really in charge of the Fed, however, is the same thing I advocated for Japan way back when: announce a fairly high inflation target over an extended period, and commit to meeting that target.

What am I talking about? Something like a commitment to achieve 5 percent annual inflation over the next 5 years — or, perhaps better, to hit a price level 28 percent higher at the end of 2015 than the level today. (Compounding) Crucially, this target would have to be non-contingent — not something you’ll call off if the economy recovers. Why? Because the point is to move expectations, and that means locking in the price rise whatever happens.

Sounds good to me. I don’t totally understand this argument, however:

It’s also crucial to understand that a half-hearted version of this policy won’t work. If you say, well, 5 percent sounds like a lot, maybe let’s just shoot for 2.5, you wouldn’t reduce real rates enough to get to full employment even if people believed you — and because you wouldn’t hit full employment, you wouldn’t manage to deliver the inflation, so people won’t believe you.

Right now we’re very far from full employment. But we still have a little inflation. And so it seems to me that if real rates go down a bit, we’ll get a bit closer to full employment, and thus a bit more inflation. The result would be a much slower than necessary recovery, but still better than the current path.