Should the Fed target the price level?
What’s at stake: Beyond the question of potential additional QE, there is an intense debate in policy and academic circles about the scope and effectiveness of adopting a price level target with the intent of driving inflation expectations higher. The bold policy move seems to be embraced by Regional Fed Presidents Dudley and Evans, respectively from New York and Chicago Feds. The move has also been mentioned in the latest FOMC minutes. More than the actual delivery of QE which markets have been raving about, the key message of the November FOMC statement may be the framework it offers.
The Fed views
David Beckworth argues that the idea of price and nominal GDP target is making inroads in the Fed. Not only the minutes mentioned the idea but more importantly, the minutes stated that participants as whole (not just one or a few) considered the proposals. Here is the relevant paragraph of the September meeting minutes: “participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP.”
Chicago Fed President Charles Evans noted in a speech that a third and complementary policy tool to 1) additional large-scale asset purchases, and 2) a communication that policy rates will remain at zero for longer than ‘an extended period – would be to announce that, given the current liquidity trap conditions, monetary policy would seek to target a path for the price level. Simply stated, a price-level target is a path for the price level that the central bank should strive to hit within a reasonable period of time. For example, if the slope of the price path, which I will refer to as P*, is 2 percent and inflation has been underrunning the path for some time, monetary policy would strive to catch up to the path: Inflation would be higher than 2 percent for a time until the path was reattained. I refer to this as a state-contingent policy because the price-level targeting regime is only intended for the duration of the liquidity trap episode.
In his speech NY Fed Chief William Dudley notes that if judged desirable, the Fed could provide more guidance on how monetary policy would react to deviations from any stated inflation objective. One possibility would be to keep track of inflation shortfalls when the federal funds rate is constrained by the zero bound, as is the case today. For example, if inflation in 2011 were a 0.5 percentage point below the Fed’s inflation objective, the Fed might aim to offset this miss by an additional 0.5 percentage point rise in the price level in future years. However, such an approach would only work well if people understood how it would operate and formed their expectations of future inflation accordingly. And there could also be significant costs. For example, if people mistakenly concluded that the Fed was tinkering with its long-run inflation objective, this could lead to greater uncertainty about future inflation. This might lead to higher risk premia and higher nominal interest rates that would undermine the effectiveness of such a policy to stimulate the economy.
Dave Altig, senior vice president and research director at the Atlanta Fed, argues that a permanent price-level targeting approach would be better than implementing the price-level targeting approach for "the duration of the liquidity trap episode" as contemplated by President Evans contemplates. The benefits of simply sticking with a price-level target is that it (a) is clearly consistent with longstanding Federal Open Market Committee (FOMC) behaviour; (b) avoids a potentially confusing impression that the central bank is jumping from one framework to another to serve whatever is convenient at the moment; and (c) gives the public a clearer way to monitor if and when the long-term price-level objective is being compromised (as can be seen by comparing the implied tolerance bounds in the two charts above). The case for a permanent price level target rests on the presumption that, in the longer run, the goal is to limit uncertainty about the purchasing power of money, thereby reducing the risk premium associated with inflation volatility and lowering the real cost of borrowing. In principle, a price-level target is a stronger commitment to this goal than is an objective based on a target for the inflation rate.
Despite all this talk from Fed officials, Federal Reserve Gov. Elizabeth Duke said "I would caution you" about reading too much into "any individual speech" by a Fed policymaker.
The case for PT
PT has been a popular research topic at the Bank of Canada over the past few years. Indeed, if you search the term on the Bank of Canada website, you get 370 relevant entries! So this is the place to go to if you need more reference on this literature.
Stephen Gordon argues that the idea here is that standard inflation targeting forgets and forgives past deviations from target. Forecasts for long-term inflation will become much less uncertain. Under inflation targeting, errors in future forecasts are accumulated; under price-level targeting, monetary policy cancels them out. It induces a stronger counter-cyclical element to monetary policy. When the price level falls during a recession, a price level target will imply an increase in the central bank's target for inflation, since higher-than-average inflation will be required to bring the price level back up to its target path. Real interest rates would be lower than what they would be under an inflation target.
Steve Ambler has a short review that points out the possible advantages of price-level targeting close to the zero bound. Under inflation targeting, if inflation is expected to remain at or close to zero for an extended period of time, followed by a return to a low targeted inflation rate, the average expected inflation rate over this period would be close to zero. Under a credible commitment to a price-level path, average expected inflation would be equal to the slope of the price-level path (the long-run inflation rate). For the same time path of short-term nominal interest rates, the long-term real interest rate would be lower by the difference in average expected inflation, resulting in stronger aggregate demand.
Models and Agents note that there are two ways in which the guidance of inflation expectations can help aggregate demand at this juncture. First, by preventing real interest rates from increasing to undesirable levels: with nominal interest rates at record lows, sustained declines in inflation expectations would translate into rising real interest rates—a rise that the Fed would be unable to “fight” by cutting the nominal interest rate further.
Michael Woodford – which for many was seen as a natural candidate for one of the previously vacant seat on the FOMC – argues that the best the Fed could do at this stage would be to allow for expectations of temporarily higher inflation to catch up with a price level path. To make this work would require some price-level type commitment, where the Fed says it would tolerate a temporary, one-off inflation overshoot, until the moment when a certain price level is reached, and when the Fed would switch back to traditional inflation targeting. He argues that this is far less disruptive to credibility, expectations and the USD than a pure and permanent change in the inflation target or in the mandate of the Fed.
Scott Sumner – who has been advocating nominal GDP targeting for months – argues the policy would have made a huuuuuge difference had it been adopted in October 2008. Remember, NGDP fell in 2009 at the fastest rate since 1938. In another post, Sumner notes that Roosevelt’s “gold-buying program” of October-December 1933 was the last time (and perhaps only other time) that the US government explicitly tried to raise the price level. The Fed better fasten its seat-belt, as the previous price level raising policy was a bit controversial. Several FDR advisers resigned in protest. If the Fed can convince markets that they can raise the price level without changing their 2% inflation target, it is likely that all markets will react positively. If they are seen as raising inflation in a semi-permanent way, stocks may still rise (albeit by a smaller amount), but bonds will sell off.
The case against PT
Some commentators have expressed concern that President Evans's proposal could encounter difficulties with credibility and communications as a shift is made from the price-level targeting period to a permanent phase that focuses on more familiar inflation rate objectives.
Gavyn Davies argues a price level target would be one too many. First, to throw away the inflation target anchor at a time when some very unconventional monetary policies are being adopted by the Fed seems much too risky. Inflation targeting has been a very useful weapon in the armoury of central banks in the course of the crisis, and it is not one to discard lightly. Second, consumers may not respond by increasing spending sooner if they see the new policy as a threat to their future wealth. Last, the policy could even backfire, by highlighting the impotency of monetary policy at a time when the economy is stuck in a liquidity trap.
Stephen Gordon points out that the potential weaknesses of price-level targeting revolve around credibility issues. If an economy had the bad luck to stumble into a recession while it was above the path, the short-term effectiveness of monetary policy would be weakened by the lower-than-trend short-term inflation target. There would be an enormous temptation to simply reset the path in the recession and start over again.
Jim Hamilton argues that although communicating from the beginning what the exit strategy from the price targeting is supposed to be in specific quantitative terms might seem attractive; it could run into a similar embarrassment as the infamous graph of the projected consequences of the economic stimulus package. Even in the best of times, the inflation rate will differ substantially from forecasts and policy objectives. And when the inevitable miss comes, one could imagine that the public would be less rather than more assured as a result of the Fed's specificity in communication.
Allan Meltzer argues the fear of mild deflation is another mistake, one commonly made. In the almost 100 years of Federal Reserve history, periods when prices declined over several months have occurred seven times. Sometimes the deflation reached 30%, yet the recoveries that followed six of the deflations cannot be distinguished from any other post-recession recovery.
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