Once seen as an extreme, even imprudent notion in the corridors of respectable central banking, the idea that a little bit of inflation is needed to let some of the air out of a decades-long debt bubble is gaining ground in establishment economics. Even the U.S. Federal Reserve, a central bank that prides itself in offering a high degree of steady predictability on inflation, is now actively pondering taking more drastic steps, such as linking the path of interest rates to the direction of unemployment or inflation.
One particularly striking passage in minutes to the Fed’s August meeting signaled such an approach was much closer to becoming policy than investors and economists had believed:
In choosing to phrase the outlook for policy in terms of a time horizon, members also considered conditioning the outlook for the level of the federal funds rate on explicit numerical values for the unemployment rate or the inflation rate. Some members argued that doing so would establish greater clarity regarding the Committee’s intentions and its likely reaction to future economic developments, while others raised questions about how an appropriate numerical value might be chosen. No such references were included in the statement for this meeting.
Reuters flagged the theme on Sept. 2 (Fed could get specific on goals if recession hits), just as Chicago Fed President Charles Evans began campaigning for such an approach, which depending on its form might be referred to as price-level targeting. Under such a regime, the Fed would allow inflation to surpass its 2 percent goal for a period, letting it rise to, say, 3 percent, in an effort to stimulate investment and economic activity. Evans argued before the European Economics and Financial Centre in London last week:
We need to take strong action now. Given how truly badly we are doing in meeting our employment mandate, I argue that the Fed should seriously consider actions that would add very significant amounts of policy accommodation. If 5 percent inflation would have our hair on fire, so should 9 percent unemployment. Such further policy accommodation does increase the risk that inflation could rise temporarily above our long-term goal of 2%. I do not think that a temporary period of inflation above 2% is something to regard with horror.