P248 inflation targeting(2)

Is inflation targeting dead? Central Banking After the CrisisWouldn’t an inflation target regime also address the Fisherdeflation spiral?Inflation target would work e.g. with liquidity provision. This way the money that hadbeen created by financial-sector lending (inside money) is replaced with central-bankcredits (outside money). However, since balance-sheet impairments of specific sectorsare not addressed, banks might simply park extra reserves with the central bank insteadof passing it to the productive cash-strapped sectors in the economy.Monetary policy could do a better job of restoring the credit flow by focusing the realproblem – the impaired balance sheets. By redistributing wealth, this counteracts theamplification coming from the liquidity and deflationary spiral.Optimal monetary policy with financial frictionsThe first step in identifying the optimal policy is to identify the sectors that suffer fromimpaired balance sheets and amplification effects. Even if the central bank can onlyresort to pure interest-rate policy, it will have to think beyond a simple Taylor rule. Ithas to identify the blockages.To see this consider an economy whose current interest rate is 2%.• If the banking sector is undercapitalised and a credit crunch is imminent, then thecentral bank could cut the short-term interest rate, say to 1%.This typically widens the term spread between the long-term interest rate and shortterminterest rate. Cutting the short-term interest rate therefore provides a ‘stealthrecapitalisation’ for banks and might be useful if their balance sheet needs to be repaired.• If the end-borrowers suffer from debt-overhang problems, e.g. households withmortgage debt, it is more important to bring down the long-run rate instead of wideningthe term spread.98