Setting the federal funds interest rate target at zero is a trap, and one the Federal Reserve would be better off avoiding, St. Louis Federal Reserve Economist Bill Gavin said at an Oct. 27 appearance at UC Santa Barbara.

Warning of the dangers of the so-called “zero lower bound,” when the federal funds rate is at zero and the Federal Reserve can no longer lower interests rates to prod the economy, Gavin advocated for the central bank to adopt a long-term numerical inflation target.

Such “inflation targeting” is already a policy used by central banks in the United Kingdom, Germany, Canada and New Zealand, and Federal Reserve Chairman Ben Bernanke has hinted in recent speeches that a similar long-term target may be under consideration in the United States.

U.S. inflation is hovering around 1 percent, and is expected to stay there for the next year, Gavin said. The Fed’s target inflation rate is currently about 1.5 percent to 2 percent. But, unlike central banks with inflation anchors, the U.S. Federal Reserve has a constantly moving target set at the discretion of the Federal Open Market Committee.

A short-term target “works almost like an explicit number at times when the economy is doing well,” Gavin said. “But it fails when there are big, long-lasting shocks like what we’ve had.”

That’s where the zero-bound conundrum comes in: When an economy is still sputtering back to life — U.S. employment likely won’t return to healthy levels for another two to three years, Gavin said — its central bank will often lower interest rates to encourage lending and spending.

But in the U.S., the federal funds rate is already at zero and can’t go lower.
Gavin argues that the only way for the Fed to achieve its dual mandate of price stability and full employment is for it to set a long-term inflationary target.

Bernanke has been a proponent of inflationary targeting and forecasting in economic papers, and said in a recent speech that a “mandate-consistent inflation rate” may be under consideration.

The Fed has already signaled that it’s likely to restart its policy of quantitative easing with large-scale purchases of long-term Treasuries, leading some observers to worry that the central bank may be too soft on inflation in the future in its desire to stimulate the economy now.

Proponents of inflation targeting argue that when investors know what the central bank considers to be its target, they can better factor rate changes into their investment choices, leading to less volatile financial markets and a more stable economy. Advocates also say that with longer-term inflationary guidance in place, investors are less likely to panic when the Fed makes sudden changes in monetary policy.

“Managing expectations is the key to successful monetary policy, but managing expectations about the wrong variables will not help,” Gavin said.

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