My post "When the Output Gap is Zero, But Inflation is Below Target" appeared on August 17, 2017. On September 13, 2017, I was pleased to see Greg Ip pick up much of the argument in my post in his Wall Street Journal article "The Fed’s Bad Options for Addressing Too-Low Inflation: The central bank’s choice: overheat the economy or give up its 2% target."
Sometimes journalists discuss a zero output gap combined with too-low inflation as if such a situation were strange, but a range of different macroeconomic theories all have the property that a zero output gap is consistent with any constant inflation rate. (This is an aspect of "monetary superneutrality.")
27 days later, Greg Ip writes:
Ms. Yellen’s worldview assumes that when unemployment is this low—4.4% in August—inflation should move up to the Fed’s target of 2%. Instead, it may have stabilized around 1.5%. That presents the Fed with some unpalatable options: deliberately overheat the economy for years to get inflation back up, then potentially induce a recession to stop it from overshooting; or give up on the 2% target, which could hobble its ability to combat future recessions.
This isn’t scaremongering: It’s the logical consequence of how central banks believe inflation operates. At the center of their model is the Phillips curve, according to which inflation edges lower when unemployment is above its natural, equilibrium level and putting downward pressure on prices and wages. Below that natural rate, also known as full employment, inflation crawls higher.
Later on in his article, Greg Ip argues that trend inflation has indeed fallen:
Since the current expansion began in 2009, inflation has persistently fallen short of 2%. ...
That leaves the third explanation: Trend inflation has fallen. ...
He uses this graph to help make that argument,
and backs it up by referencing the Fed's own internal deliberations:
In 2014, Fed staff slightly revised down its own assessment of trend inflation, according to minutes to the central bank’s June meeting that year. ...
Greg Ip sees a dilemma:
Raising inflation half a point could require letting unemployment drop to around 3.5% and keeping it there for five years. Then, to prevent inflation from overshooting, the Fed would have to slow the economy and guide unemployment back over 4%. In theory it could do this gradually enough to avoid a recession; in practice, the number of times since 1948 when unemployment has gone up that much without a recession is zero, according to Goldman Sachs.
The alternative is to ditch the 2% target and accept 1.5% as the new inflation trend.
I see much less of a dilemma. Here from my post: "When the Output Gap is Zero, But Inflation is Below Target":
To bring inflation back up to target would require a period of time with a positive output gap.
Since positive output gaps are pleasant given all the distortions that make the natural level of output lower than the level at which (other than the effects on inflation) the marginal benefit of output equals the marginal cost, why don't central banks shoot for a positive output gap until inflation returns to the target of 2% per year? I think the answer is:
1. Central bankers are not used to trying to have positive output gaps. The low unemployment rates associated with positive output gaps seem dangerous.
2. Central bankers don't really like having an inflation target above zero. They feel in their bones that their job is to keep inflation down, close to zero, not to push it up.
I then go on to point out that it is OK to have a lower inflation target when one is prepared to use negative interest rates, as I discussed at length in "The Costs and Benefits of Repealing the Zero Lower Bound...and Then Lowering the Long-Run Inflation Target." What a central bank thinks about negative interest rate policy matters even when the central bank is not currently using negative interest rates.