The signaling effect of raising inflation

Abstract

This paper argues that central bankers should raise inflation when anticipating liquidity traps to signal their credibility to forward guidance policies. As stable inflation in normal times either stems from central banker's credibility, e.g. through reputation, or from his aversion to inflation, the private sector is unable to infer the central banker's type from observing stable inflation, jeopardizing the efficiency of forward guidance policy. We show that this signaling motive can justify level of inflation well above 2% but also that the low inflation volatility during the Great Moderation was insufficient to ensure fully efficient forward guidance when needed.

Credible Forward Guidance

“…10 See also Barthélemy and Mengus (2018) who examine sustainability of optimal commitment policy in a model with the ELB constraint in which the central bank's objective function-either a benevolent or conservative kind-is unknown to private-sector agents and there is an inflationary bias. In their model, the benevolent central bank can make the optimal commitment policy sustainable by raising inflation prior to a liquidity trap and signaling its type to private-sector agents.…”