The central bank has three options if the economy is at the zero bound, and is also likely to stay there if the central bank maintains its current inflation target:
1. The Chuck Norris approach; buy up as many assets as it takes to hit the expected inflation target. They can also reduce IOR if they don’t want to buy so many assets.
2. Set a higher inflation target, or switch to price level targeting, or switch to NGDP level targeting. All of these options effectively raise the short term inflation target, but they don’t necessarily affect the long run rate of inflation. This will allow the central bank to boost NGDP and simultaneously reduce the base.
Most modern central banks say options one and two are out of the question. One is too risky and two would lead to a loss of policy credibility. That leaves option three:
3. Abject failure.
Note that option 3 is actually far more costly and risky than option one, and entails an even greater loss of credibility than option two.
I’ve recently read dozens of articles attached to student essays, written by both economists and journalists. The vast majority can be boiled down to the claim that if the Fed follows policy option three, abject failure, it is unlikely to succeed. You don’t say!
BTW, Readers may have assumed that this post applies to the current situation in the US. That’s not at all clear to me. It might apply, but I’m not certain. The Fed has a dual mandate; it’s not a pure inflation targeter. Thus it’s not obvious that the zero bound is actually what’s inhibiting Fed policy, one could argue that it is a reluctance to take the employment half of the mandate seriously. After all, on several occasions they backed off of QE because inflation was too high. Thus it’s not clear that the Fed would have to buy more assets to hit its Congressionally-given mandate. It might merely need to announce that it intends to do so.
On the other hand it’s certainly possible that it would have to buy more assets.