Blanchard writes “Monetary policy will never be the same”. (I could imagine tears in his eyes):
Now let me now turn to monetary policy…
On the liquidity trap: we have discovered, unfortunately at great cost, that the zero lower bound can indeed be binding, and be binding for a long time—five years at this point. We have also discovered that, even then, there is still some room for monetary policy. The bulk of the evidence is that unconventional policy can systematically affect the term premia, and thus bend the yield curve through portfolio effects. But it remains a fact that compared to conventional policy; the effects of unconventional monetary policy are very limited and uncertain. [“conventional policy” means interest rate policy]
There is therefore much to be said for avoiding the trap in the first place in the future, and this raises again the question of the inflation rate. There is wide agreement that in most advanced countries, it would be good(!) if inflation was higher today. Presumably, if it had been higher pre-crisis, it would be higher today. To be more concrete, if inflation had been 2 percentage points higher before the crisis, the best guess is that it would be 2 percentage points higher today, the real rate would be 2 percentage points lower, and we would probably be close in the US to an exit from zero nominal rates today.[forgetting it was exactly because headline inflation went up in 2008 that the Fed ‘stepped on the brakes]
We should not dismiss the possibility, raised by Larry Summers that we may need negative real rates for a long time. Countries could in principle achieve negative real rates through low nominal rates and moderate inflation. Instead, we are still facing today the danger of an adverse feedback loop, in which depressed demand leads to lower inflation, lower inflation leads to higher real rates, and higher real rates lead in turn to even more depressed demand.
Until we start seeing monetary policy being discussed without direct reference to interest rates and inflation I believe we´re doomed to stay ‘trapped’.
In 1981, given entrenched inflation expectations, to obtain a significant reduction in inflation the Fed ended up provoking an also significant increase in unemployment. By 1984 the ‘back of inflation expectations had been broken’, so the Fed was successful in engineering a rise in spending which was accompanied by a drop in both inflation and unemployment. 2009 is the ‘half opposite’ of 1984. With inflation expectations ‘stable’, the steep fall in spending by the Fed results in a big increase in unemployment.
So what we have now is a situation where the Fed (and other central banks) has fallen into an “expectations trap”. That´s the expectation by the public that inflation will remain on ‘target’ (little risk of inflation being either ‘too low’ or ‘too high’). Since it´s not advisable (for both political and economic reasons) to try to ‘pull-out’ of this ‘trap’ by ‘inducing’ people to increase their expectations of inflation, the best option is to change the ‘target’. And the most promising alternative is an NGDP level target.
Australia is a case in point. As I argued here, Australia did not let NGDP tank like many other developed countries. The result is that it shook-off both the Asia crisis of 1997/98 and the international ‘financial’ crisis of 2008/09.
I like Blanchard´s title. It indicates we have to undergo a ‘regime shift’!
Maybe a clearly specified nominal target other than inflation?