Scott Sumner has an excellent post also on the subject of the WSJ piece by Mishkin and Woodford, and more generally on the inadequacy of interest rates as a monetary policy tool at the zero lower bound. Here’s a quote from Scott’s post;
We need a new policy instrument, one that doesn’t become mute when nominal rates fall to zero. We could use the monetary base (QE), but I would prefer pegging the price of NGDP [Nominal GDP] futures contracts. And then adjusting the monetary base as required to keep the Fed’s net position in the NGDP futures market close to zero.
I largely agree with Scott’s longstanding view that a nominal GDP target would be a better nominal anchor than a pure inflation target (although I’m probably not as wholeheartedly sold to the idea as Scott is), and although I may not go the whole way to suggesting the launch of NGDP futures contracts and having the monetary authority directly target these assets, when you have a monetary authority target either a price level or an NGDP level rather than an annual change in prices, and crucially a commitment to do so is perceived to be credible, then the zero lower bound in my opinion can indeed be overcome by monetary expansion. The crucial element to either the price level or NGDP level target is that both policies possess reversion qualities. Take the price level target – if a monetary authority were following such a target at a 2% annual rate and undershot their target, then over some period in the future inflation will have to be greater than 2% so that the price level is stabilized on its prior path. This quality becomes especially important in times of a liquidity trap. For instance, take the below figure from a paper written by Gauti Eggertsson and Michael Woodford.
Although rather complex looking, the graphs are actually very illustrative of what the optimal policy entails (according to the solution of the authors’ DSGE model, and most other models on the subject). In these graphs, each line corresponds to the optimal monetary policy when the liquidity trap persists for different periods of time, with the duration of the liquidity trap set exogenously. Take graph (a). The first spike in the grey line corresponds to the optimal course of inflation when the liquidity trap persists for one period. If the liquidity trap persists for 2 periods then the next grey line to the right corresponds to the optimal path of inflation and so on. The same applies to the graphs for the output gap and the price level. Taking a look at graphs (a) and (c) it is clear that the longer the liquidity trap persists for i.e. the longer the economy finds itself mired in a deflationary spiral, the greater the level of inflation that is needed under the optimal policy. Thus we can see from graph (c) that the longer the liquidity trap persists, the higher the price level at which the economy is eventually stabilized. This is exactly what is meant by price-level reversion, and is exactly what is required to escape a situation characterized by insufficient aggregate demand and interest rates up against the zero bound.
Update – David Beckworth has a nice graph which illustrates the reversion characteristics of an NGDP level or price level target.