A Two-Headed Dragon for Monetary Policy
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The current financial crisis has been the key global economic event since it unfolded in earnest in early August 2007. The Federal Reserve has taken aggressive actions—both conventional and unconventional—to counteract the economic and financial fallout. Among these actions have been a number of new special lending programs created under section 13(3) of the Federal Reserve Act, which had not been employed since the 1930s. Academics, policymakers, and the general public have shown great interest in the Federal Reserve's new programs. In this paper, I emphasize two medium-term risks that the Federal Reserve now faces as it continues to confront financial market turmoil and recession. The two medium-term risks are opposites of each other, a “two-headed dragon.” One is a Japanese-style deflation trap, and the other is a breakout of inflation like that seen during the 1970s. An explicit inflation target would help mitigate these very real risks.
Keywordsmonetary policy reserve balances quantitative easing
I appreciate assistance and comments provided by my colleagues at the Federal Reserve Bank of St. Louis. Kevin Kliesen, associate economist, and Marcela M. Williams, special research assistant to the president, provided assistance.
The authors are employees of the US Government and this contribution was prepared as a part of their duties, consequently copyright in the text of this article resides with the US Government.
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