Japan's central bank took the extraordinary move of targeting a higher rate of inflation, setting a 1.0 percent inflation target. This should have been front page news.

The idea of a central bank setting an inflation target above its current level, in the hope of raising inflationary expectations, dates back to a paper by Paul Krugman in the late 90s. (Federal Reserve Board Chairman Ben Bernanke endorsed the same policy when he was still a professor at Princeton.) The logic is that if the central bank can credibly commit itself to a higher inflation target then the commitment could create self-fulfilling expectations. Businesses would invest and consumers would spend based on the expectation of higher inflation, which would mean a lower real interest rate. The increased business activity would then lead the inflation targeted by the bank.

This decision by the Japanese central bank will provide an opportunity to test whether such targeting can work. If it proves successful, it may lead to more pressure on other central banks (like the Fed) to go this route.

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