First, I doubt that a higher inflation target would be viewed as consistent with the Federal Reserve’s Congressional mandate to pursue price stability. Our employment and inflation mandates have been established by Congress, not by the Federal Reserve. Second, the risks of being pinned at the effective lower bound for interest rates may be overstated. Only once in the postwar period have we reached the zero lower bound. Upending several decades of effort to anchor inflation expectations around 2 percent might be too high a price to pay to reduce the effective lower bound risk by what might prove to be a small amount. In this vein, it is important to recognize that the FOMC now has a more credible set of tools available to use at the effective lower bound than it did in 2008, when those tools were largely unproven. Forward guidance about the path of short-term interest rates and quantitative easing have been effective in providing monetary policy stimulus in the post-crisis period. Because this is now more broadly appreciated, households and businesses should be more confident that the Federal Reserve has sufficient tools available at the effective lower bound to generate a sustainable economic recovery. This greater confidence, in turn, should help keep inflation expectations from declining—which should also mitigate the risks associated with hitting the lower bound. Third, there are arguably better ways of reducing risks associated with the effective lower bound than a higher inflation objective.
For example, if we are in a period of “secular stagnation”— characterized by chronic excess global savings and aging populations—then one would expect r* to remain persistently low. 3 But, if we are in a world of abating headwinds as we recover from the financial crisis, then one would expect r* to rise over time. This lack of clarity about the environment increases the degree of uncertainty about the level of r*. Despite all these uncertainties, one still has to have a viewpoint. In the current circumstances, I would judge that r* over the medium term is likely to be somewhere around 1 percent. Although that is higher than the estimates from some models, I have nudged up my estimate because financial conditions are still easy and fiscal policy will likely be quite stimulative in 2018 and 2019.4 If the neutral real interest rate is around 1 percent, there is still some distance to go before monetary policy actually gets tight. At the FOMC’s 2 percent inflation objective, my estimate of r* implies that the federal funds rate would need to rise to around 3 percent for monetary policy to be considered neutral. Of course, as the factors that influence r* change, my estimate of r* will also move around over time. 2/7  BIS central bankers' speeches  Whether monetary policy will need to move to a restrictive setting depends crucially on how low the unemployment rate can go without inflation climbing meaningfully above 2 percent.