For months now some at the Fed have been wishing they could lower rates even more, and if rates were not at zero the Fed would be cutting. Janet Yellen said in June “If we were not at zero, we would be lowering the funds rate.” In fact many are saying the appropriate Fed Funds Target rate now should be negative 2-4% given where the economy is. But of course that's impossible and quantitative easing (securities purchases) is used as an alternative tool.
But some are suggesting that if the Fed had been more accommodative earlier, the starting target rate would have been higher and the Fed would have more room to cut. In the last two decades global rates have stabilized at relatively low levels with central banks constantly ready to fight inflation. In a recent paper, John Williams of the San Francisco Fed suggests that one way to give the Fed more room is to increase the target inflation rate to 4% from about 1.5 - 2% currently (although the Fed officially does not publish a target rate).
The higher inflation target rate would keep rates under normal growth conditions higher, giving the Fed (or any other central bank) more room to cut. The chart below (from Williams' paper) shows how the ability to cut rates further would have blunted the rapid growth in unemployment.
The zero lower bound [ZLB] has significantly constrained the ability of many central banks to stimulate the economy in the current recession. If this is a unique, extraordinary incident, it would have no implications for the choice of an inflation goal. If however, the current global recession represents the death knell of the era of the Great Moderation and the equilibrium real interest rate remains low, then the ZLB may regularly interfere with the ability of central banks to achieve macroeconomic stabilization goals.
The danger of such policy of course is that inflation can remain low due productivity growth and pressures from low cost manufacturers, while asset bubbles can quickly build up. Many argue that this in fact was the mistake of the Greenspan's Fed that allowed the buildup of the credit bubble. For that reason the target inflation rate is unlikely to be moved up significantly, but some increases as well as an explicit target rate (used by most non-US central bankers) are indeed possible.
