I recently wrote an article for the forthcoming Global Economic History Encyclopedia about inflation targeting. I only submitted the article for editing a few days ago, but it looks like it may be due for updates before the encyclopedia even comes out! The reason is news that Shinzo Abe, future premier of Japan, is pressuring the Bank of Japan (BOJ) to adopt a 2% inflation target. Apparently, if the bank refuses, Abe will try to change the law guaranteeing BOJ independence. Currently, the BOJ has a 1% inflation target. This is pretty big news, but I haven't seen any economist's analysis in the press yet, so I'll try to walk through some of the basic implications.
The Japanese economy experienced deflation and economic stagnation in the 1990s, recovered somewhat from 2003 to 2007, then fell back into recession. Consumer prices have fallen 6.8% since 1997. Richard Koo's book calls the extended Japanese recession "The Holy Grail of Macroeconomics" because of the light it can shed on macroeconomic theory. Paul Krugman has also repeatedly looked to Japan to study the macroeconomy under conditions of recession, deflation, and the liquidity trap.
To analyze the news about the possible 2% target, something to keep in mind is the relationship between interest rates and inflation. The nominal interest rate is the real interest rate plus expected inflation. There is a zero lower bound (ZLB) on nominal interest rates, since potential lenders would rather just hold cash than lend at negative nominal interest rates. Real interest rates affect decisions about spending and investing now versus later, so they affect aggregate demand. Typically in a recession, monetary authorities want to lower interest rates to boost aggregate demand. A certain level of real interest rates would theoretically restore full employment. But, especially when inflation is low or negative, the ZLB on nominal interest rates can prevent the real interest rate from going sufficiently low. This situation is called a liquidity trap, and renders conventional monetary policy obsolete.
Since the real interest rate is the nominal rate minus expected inflation, raising expected inflation can help lower the real interest rate. But raising expectations about future inflation is not a straightforward task. If a central bank starts printing a lot of money, the public still might not believe that it would continue to do so in the future, when the bank's incentives would be different. One purported solution is for the bank to publicly and explicitly commit to an inflation target. The public commitment is intended to add credibility, so that expectations will actually change.
The other relevant relationship is between exchange rates and inflation. If inflation in Japan is expected to be higher, then the yen will have less purchasing power in the future, so the yen will depreciate. Depreciation of the yen makes Japanese exports relatively cheaper and imports relatively more expensive. So a higher inflation target could reduce Japan's trade deficit, which has been large this year.
My final comment is that central bank independence is not a goal in and of itself. It may be a means of arriving at the goal of effective monetary policy, or it may not. Typically, central bank independence does facilitate effective monetary policy by adding credibility. But at the moment, the BOJ is not credible enough to achieve its 1% inflation target. Maybe if the 2% target were instituted by another part of the government considered more credible, it would actually be more effective. In conclusion, I am somewhat hopeful that Japan is headed in a good direction. Either the BOJ will adopt a 2% target, which will be seen as more credible due to government support, or the government will itself impose the target, which would be drastic enough to cause the markets to notice, bringing about some aggregate demand stimulus.
P.S. I haven't written in awhile for two exciting reasons. First, I have been working on articles for the Global Economic History Encyclopedia. Along with inflation targeting, I have written about the euro area, the Basel Accords, the National Monetary Commission, the gold standard, the Glass-Steagall Act, Wildcat Banking, the Credit Anstalt Crisis, and a few others.
Second, I haven't been writing because I was too busy getting married and going on a honeymoon! I married Joe Binder on December 1 at Christ the King Catholic Church in Dallas, TX. Then we drove across the Southwest for our honeymoon, stopping at a lot of national parks and monuments including Carlsbad Caverns, Guadalupe Mountain, White Sands, Tucson, Sedona, the Gila Cliff Dwellings, and the Grand Canyon. We feel so happy and blessed and are excited about our first Christmas together!