Glen Hodgson asks whether the Bank of Canada's 2% inflation target is too low. He is right to ask that question. I want to explore the trade-offs.
Suppose you are a macroeconomist (like Simon Wren-Lewis) who believes that the Zero Lower Bound on nominal interest rates will be a binding constraint in some circumstances, and so monetary policy alone will sometimes be unable to hit the monetary policy target, and will need help from fiscal policy. Maybe you should change the monetary policy target instead, so those circumstances never arise?
But there's a better way to think of it.
Think of a world with a continuum of assets of different liquidity. The central bank issues the most liquid asset ("currency"), but there is a second asset just infinitessimally less liquid than that, and a third asset just infinitessimally less liquid than that, and so on. The central bank has currency on the liability side of its balance sheet, and a spectrum of the slightly less liquid assets on the asset side of its balance sheet. In that world the ZLB would always be binding on some asset, the one at the margin of the central bank's operations, but it wouldn't be a constraint on the central bank. The central bank would buy up all of that asset, then move on to the next asset along the liquidity spectrum, if it needed to. Monetary policy would mean moving the ZLB back and forth along the spectrum of assets.
"WIll the ZLB be a binding constraint, so that fiscal policy is needed?" is not the right question. Instead we should ask: "How big do we want the central bank to be?"
The size of the central bank will depend on the monetary policy target. If the central bank targets 100% inflation (or 103% NGDP level growth) the central bank's balance sheet would be very small (relative to GDP). That's because currency would pay minus 100% real interest per year, so the demand for currency would be very small relative to GDP. Fluctuations in the demand for currency would need to be accommodated by the central bank, so the size of the central bank would need to fluctuate to keep inflation on target, but the average size of the central bank would be very small, and the absolute size of those fluctuations in size would be very small too.
As we lower the inflation target (or NGDP level growth target), the demand for the central bank's currency would increase, the average size of the central bank would increase, relative to GDP, and so would the absolute size of those fluctuations in size.
How low do you want the inflation target to go? How big do you want the central bank to be? How big do you want the fluctuations in size of the central bank to be?
Do you want a central bank that sometimes needs to own all the government bonds, all the commercial bonds, all the shares, all the farmland, all the houses...to keep inflation (or NGDP) on target?
You probably don't. (Unless you are some sort of extreme socialist who wants the government-owned central bank to own everything.)
If the inflation target is too low, and the central bank is too big, and owns a lot of assets that central banks don't normally own, and has to keep buying and selling lots of those assets that central banks don't normally buy and sell, to keep inflation (or NGDP) on target, is that fiscal policy by the central bank? You tell me. But does it really matter what we call it?
(I think an NGDP level-path target would have automatic stabiliser properties that would result in smaller fluctuations in the size of the central bank for any given average inflation rate than would an inflation target. But that's a separate question.)