The whole problem with monetary policy in a liquidity trap is the inability for a central bank to commit to a permanently expanded monetary base. Iterations of this dilemma are captured best by Paul Krugman’s quip that the Fed cannot “credibly commit to be irresponsible”.
Actually, it can. We have a Fed that cannot actually be irresponsible. Markets know the second inflation hits 3-5% the brakes are coming hard, which asphyxiates expansionary fire today. Nothing short of complete institutional change of a decentralized system like the Federal Reserve can change it’s limitation.
But the Fed doesn’t actually need to be irresponsible, it must only convince markets that it can be. I suggest Ben Bernanke release a statement – or, better, the FOMC as a whole in its minutes – that he is expecting 5% annual inflation, even if he is expecting far less. That way, the FOMC privately knows deflation exists and quantitative easing will not do anything, and continue the huge asset purchases. But the market will be confounded. The world’s most conservative institution is ignoring inflation at even 5% – surely that means the brakes won’t come down all too hard in the future.
This will immediately provide traction to monetary policy even at the zero lower bound and will prevent the complete sterilization of expanded base as we currently experience.
In fact, even a Federal Reserve of many inflation hawks can do this successfully. They personally know deflation is real, but they can hide that private knowledge. Of course the markets will know the real PCE and CPI, but the only metric that’s important is the Fed’s own expectation.
Or we could completely reform the Federal Reserve, but that’s the real #slatepitch here.