I thought I understood the idea of inflation targeting....

...until I read this utterly confounding post by Paul Krugman.

Whether you love him or hate him, one must admit this is unusual for PK.  Usually he is exceptionally clear and logical.  I suspect there probably is some deeper logic here than meets the (or at least my) eye, and I suspect we'll be hearing a lot more from Krugman and others on inflation targeting.

There is also the possibility that my skull is thicker than usual this evening.

In any case, kudos to him for finally writing more about the topic.  I was kinda wishing he and others would have done more of this, oh back in February of 2009.

In the meantime, I really like Jim Hamilton's perspective on the issue.  The basic idea is to always have a long-run inflation target in mind, say 2%. Then, have medium-run targets for inflation that take into account cumulative off-target inflation in the past.  So, following a few quarters of disinflation, the Fed should target a somewhat higher inflation target going forward to make up for below-target inflation in the past.   The more disinflation we have, the more the Fed should target "catch up" inflation in the future.  This seems like a naturally stabilizing policy that is also very conducive to long run stability of expectations.  I also think it is deeply true to Fiedman's monetarism--the kind of thing that might elicit support of economists across a broad spectrum.  After all, Bernanke does have to carry along an unusually divisive Federal Open Market Committee.  I also think it would work a lot better than a vague QE2 policy would.

Update:   I also like Karl Smith's line on inflation targeting: permanently change the target to 4%.  Even a permanent change to 3% may do the trick.  Besides the many reasons Karl gives, one biggie is that this reduces the chance that we'll hit the zero lower bound in future recessions.  (I think he alludes to this when he says it will "serve as a buffer against future economic crises...")  There is also good bit of reasoning and evidence that a modest amount of inflation reduces the amount of real wage rigidity in the economy, which effectively reduces the incidence of and depth of recessions.  I think this is a good reason for a higher target inflation rate even if we weren't stuck in a liquidity trap.  If the Fed were to say as much it could be a big shock to help push things along.  Even though there is no indication at all that they plan to do such a thing, after another year or two of stagnation, they just might.  After all, Janet Yellen has done some of the work suggesting a higher inflation rate is probably better for the economy anyhow.


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