Limitations of Raising Expected Inflation to Increase Aggregate Demand

Robert Samuelson is getting a bit of praise for this Battle of the Beards:

What we need now — and what the Fed could supply, says Krugman — is a bit more inflation. This would spur growth and job creation, he argues. The Fed now strives to keep inflation around 2 percent annually, a low level that it views as reassuring the public. Krugman wants the Fed to raise its target range to 3 to 4 percent for five years.

I’m for anything we can go to get our currently anemic aggregate demand to increase. But note that at current market rates for 10-year government bonds – nominal being just under 2% and real being around a negative quarter percent – we have already passed this 2% inflation target at least for now. OK, telling markets we will tolerate 3% inflation for the next 5 years could further reduce real borrowing costs even as short-term nominal rates hover around zero. I think, however, that James Hamilton has a point here:

I pointed out that the direct stimulative effects of a debt maturity swap were decidedly minor. The conclusion I draw from these two observations is that we might have to push on this lever extremely hard to get anything accomplished, and that pushing on the lever is not without its own dangers. My position is therefore that the Fed is correct in viewing this particular tool as one that should be used with caution.

Even if the Federal Reserve could further reduce real interest rates to 1% by letting expected inflation be 3%, how much extra private demand will this really create? This type of liquidity trap where national savings at full employment greatly outstrips private investment even at negative real interest rates calls for an outward shift of the IS curve more than a movement along the current IS curve. Of course, a more expansionary fiscal policy is clearly called for – an issue where both Bernanke and Krugman have agreed repeatedly. Alas, some powerful members of Congress choose not to listen.