The 2% solution for the Fed

The Fed does not seem to know what to do other than to keep interest rates low. QE3 is possible but the Fed is not willing to commit.

Core inflation is below its target of 2% but close at 1.8%. Perhaps the right target for the Fed should be to make it clear that it will follow closely a policy of keeping inflation no lower than 2%. This policy is not the same as keeping it at 2%. It is not an inflation policy, but it will tell the market that it is not willing to allow prices to fall. It would be a clear mandate to have deflation not be an issue. If bonds need to be bought so be it. The policy will be clear that QE will occur as long as inflation is below 2% and will not be conducted if above.

This 2% solution is consistent with some leading economist who want to see 2% inflation. Now saying that you will not tolerate deflation will mean that many prices will have to go up above 2% given that housing is still declining or at best flat. It provides clarity and operation objectives.