The Fed is currently contemplating a set of monetary policy changes that might be viewed as “second best”. These include yield curve control and average inflation targeting. With yield curve control the central bank would peg the yield on longer-term Treasury bonds. This was Fed policy during the 1940s. Under average inflation targeting the central bank tries to make up for an inflation undershoot or overshoot, so that inflation will average 2% over the business cycle.

In my view, these are second best policies.  Holding down long-term interest rates might be expansionary, but it also might end up being contractionary.  After all, contractionary monetary policy can easily decrease long-term interest rates by reducing expectations of inflation and economic growth.

Average inflation targeting might be expansionary during a recession, but it also might lack credibility for exactly the same reason that the current inflation targeting regime lacks credibility; there is no hard and fast commitment to make up for inflation undershoots, just an intention to try to do so.

In my view, first best policies would involve level targeting (of prices or better yet NGDP) and a “whatever it takes” approach to monetary expansion to hit those level targets.  That’s the only policy regime that would give me confidence that the Fed would actually hit its target over the very long run.

So here’s the question.  Should we view the adoption of second best policies as a step forward, even if not optimal?  Or would they be a step that makes the optimal policy less likely?  That is, would average inflation targeting involve the opportunity cost of rejecting level targeting?

What do you think?

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