And so instead of building a powerful, unrelenting case for further fiscal easing, mainstream progressives are focused on the Fed, demanding that it do just as much to promote growth and employment as it does to promote price stability. How? By following Krugman’s advice and “credibly committing to a higher inflation target,” which, it is argued, will stimulate spending by lowering the real rate of interest. It’s a policy recommendation that only an economist (or someone with enough credit hours to be dangerous) could conjure up. I almost hope the Fed tries it so that we can banish this proposal to the wasteland of failed policy recommendations (along with QE1, QE2 and Operation Twist). But millions of Americans are suffering and so I really do not want to see us pursue a losing policy just because the alternative looks like a political nonstarter.
The zero bound isn’t the problem. Brazil’s central bank has cut its policy rate by 400 basis points since August 2011. That’s 4 percentage points in under a year! Meanwhile, growth continues to slow and inflation is falling. Why? Brazil isn’t up against the zero bound (far from it, rates are at 8.5 percent). The problem is that monetary policy is a blunt instrument (at best). Committing to a higher inflation target isn’t going to pull us out of the economic doldrums.Spotted the error? Kelton says an inflation target won't work, and cites Brazil, which did not adopt an inflation target. Instead, they cut rates. I agree, that's a blunt instrument, but it's nothing at all like adopting an inflation target.
Let's step back a second. A central bank has absolute, unquestioned control over the supply of currency. They can create arbitrary quantities of it at nearly zero cost. If they commit themselves in public to inflating that currency by some percent, and take serious steps to start up the presses, you'd have to be insane to bet against that inflation. Or, consider this analogy:
Imagine a situation in which you are the only person in the world who’s capable of producing diamonds. But you also have the ability to produce arbitrary quantities of diamonds, at any time, instantly, and at zero cost. Now why on earth would anyone worry that you might be unable to reduce the price of diamonds? I think that if someone in that position said, “I want to make diamonds 25 percent cheaper and intend to do whatever it takes to make that happen” that the price of diamonds would fall more or less immediately by roughly 25 percent. After all, the magical diamond man has promised he’s going to make this happen. You probably wouldn’t need to do anything at all. To be sure, just to show the world that you’re not a jerk and to maintain your credibility for the future it would probably be wise to follow-up the crash in the diamond futures market with the production of some actual new diamonds. So instead of diamonds, say you had the ability to produce arbitrary quantities of dollars….For how a bit more inflation might help the recovery, see here. Krugman's case is stronger than Kelton says, and she doesn't address how inflation helps erode the real value of debt, while strangely insisting that fiscal stimulus (more government spending) is the way to...help households deleverage.
Finally, Kelton also doesn't address what is probably the most effective action the Fed could take: namely, printing money and giving it out to everyone (or just electronically adding $10,000 or whatever to everyone's bank account). If we're still lagging in aggregate demand—meaning we don't have enough spending throughout the economy—then handing out money is about the most straightforward way to get some. It sounds crazy, which is probably why it's so politically implausible, but the economics are ironclad.
UPDATE: I should clarify that I'm not against fiscal stimulus either, just that monetary policy is also important, and does work. These are two great tastes that taste great together. Furthermore, there is a real danger than any economic recovery kicked off by fiscal stimulus would be strangled in a the crib by a Fed fanatically committed to 2 percent inflation uber alles.