Promising higher prices, which would increase inflation, may be the best policy to relieve credit market stress when zero lower bound rates threaten, according to a study released by the Federal Reserve Bank of St. Louis Thursday.
Looking at how monetary policy can repair "credit market imperfections" in a zero lower bound environment, Federal Reserve Bank of St. Louis President James Bullard and other authors suggest "promising an increase in the price level in the following period sufficient to prevent reaching the zero lower bound."
In a conference call, Bullard said in the paper it is assumed policy makers could control the price level precisely with something that would look like a nominal gross domestic product target.
Bullard said, "You would print a lot of money to increase the price level." He added, "Higher inflation hurts cash users, so you don't want to make it too high."
"The bottom line of the analysis is that in this framework, versions of nominal GDP targeting constitute optimal monetary policy," Bullard said in the conference call. "What this means is inflation would be relatively high in periods of low growth and relatively low in periods of high growth."
The paper, titled "Optimal Monetary Policy at the Zero Lower Bound," suggests normal forward guidance is "not a good policy choice" and it is "unclear" how quantitative easing would work, so that wouldn't be a good option either.
The report, co-authored with Costas Azariadis of Washington University in St. Louis and the Federal Reserve Bank of St. Louis, Aarti Singh of the University of Sydney, and Jacek Suda of the Narodowy Bank Polski, suggests future research is needed since "policy implications of the model appear to be quite different from current policy."
