The signaling effect of raising inflation

This paper argues that central bankers should temporarily raise inflation when anticipating liquidity traps to ensure the credibility of otherwise time-inconsistent forward guidance policies. As stable inflation in normal times either stems from central bankers' desire to maintain credibility or from aversion to inflation, the private sector is unable to infer the central banker's willingness to follow through on promises from observing stable inflation, jeopardizing the efficiency of forward guidance policy. We show that this signaling motive can justify temporary deviations of inflation from target well above 2%, but also that the low inflation volatility during the Great Moderation was insufficient to ensure fully efficient forward guidance when needed.