Now that I am already way out on a limb, I should emphasize that my remarks reflect my own views and not necessarily those of the Federal Open Market Committee or anyone else in the Federal Reserve System. As a starting point, it’s useful to travel back in time to the 1980s and 1990s, when inflation targeting was introduced. The problem at the time was high and variable inflation that contributed to macroeconomic instability and unmoored inflation expectations, which in turn fueled high and variable inflation. To break this vicious cycle, numerous central banks instituted inflation targeting, or variants thereof, with a focus on bringing inflation down to a low level and fostering the establishment of stable, well-anchored inflation expectations. This strategy worked extraordinarily well in the decade preceding the global financial crisis, as central banks were able to achieve remarkably low and stable inflation, leading to a positive feedback loop between low inflation and well-anchored inflation expectations. Today, we face an altogether different set of problems stemming from a very low neutral interest rate—that is, the short-term real interest rate consistent with an economy operating at its potential alongside low and stable inflation. Ironically, the problem we need to solve these days is the risk of inflation that is persistently too low, rather than too high. Today’s low neutral interest rates reflect the culmination of trends extending back 25 years.
This shortfall of monetary accommodation would result in less desirable economic outcomes during the recession and recovery. In particular, inflation would typically undershoot its desired target during these episodes. The persistence of belowtarget inflation rates in many advanced economies over the past decade is a testament to this dynamic. As a result of the inherent asymmetry introduced by the lower bound on interest rates, an inflation-targeting central bank could experience inflation that is below target, once we consider the average inflation rate over periods when policy is constrained and those when it is not. With inflation on average below the target level, inflation expectations will likely slip below the target rate as well.5 A simple example helps illustrate this problem. Say that 80 percent of the time, the lower bound on interest rates does not constrain policy and the central bank aims for a 2 percent target inflation rate. During these “good” times, an inflation-targeting central bank aims to keep inflation near 2 percent. But, 20 percent of the time, the economy falls into a recession that’s severe enough that the lower bound constrains policy. Assume that during these periods, inflation averages only 1 percent. So, 80 percent of the time inflation averages 2 percent and 20 percent of the time inflation averages 1 percent. The resulting average rate of inflation is about 1.8 percent. As a consequence, inflation expectations are likely to become anchored at the long-run average of 1.8 percent, below the desired 2 percent target. But, that’s not the end of the story.