Reinhart explained that Bernanke faces two problems now that the Fed has effectively shifted from interest rates to quantitative easing as a means to stimulate the economy: communication and governance. The former involves how to explain the purpose of the Fed’s myriad credit programs and resulting expansion of bank reserves. The latter involves the division of responsibilities between the Washington-based Fed Board and the Federal Open Market Committee that includes regional bank presidents.
Inflation targets address both.
When official interest rates are as near zero as they are now, the Fed can’t offset deflationary forces with interest rate cuts to keep inflation-adjusted private borrowing costs down. But an inflation target would convey to the public that officials will use other means, like the Fed’s balance sheet, to prevent prices from falling and also keep inflation expectations from falling too low.
A target might also ease concerns that expansionary fiscal and monetary policy now will sow the seeds of an inflationary outbreak later, and would provide officials a framework with which to eventually unwind their credit programs and rate reductions.
Targets might also head off any friction between the Board of Governors and FOMC. According to Tuesday’s minutes, a “few” FOMC participants wanted the Fed to consider reserve targets to better coordinate between the Board — which sets new lending facilities — and the FOMC, which controls open market operations.
Friday, January 9, 2009
According to this Wall Street Journal article, risk of deflation could help to accelerate the introduction of a new monetary regime. Here's how it could fix some of the problems faced by Bernanke: