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October 20, 2010

A good time for price-level targeting?

Though the idea arises periodically, interest in price-level targeting is a hot topic again thanks to recent comments from Federal Reserve Bank of Chicago President Charles Evans. The essence of Evans's approach (and described in his own words) is this:

"If the Federal Reserve decided to increase the degree of policy accommodation today, two avenues could be: 1) additional large-scale asset purchases, and 2) a communication that policy rates will remain at zero for longer than ‘an extended period.'

"A third and complementary policy tool 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."

The challenge presented by short-term interest rates near zero is one clear motivation for this policy proposal. Again, from President Evans:

"Risk-free short-term interest rates are essentially zero. Both households and businesses have an excess of savings relative to the new investment demands for these funds. With nominal interest rates at zero, market clearing at lower real interest rates is stymied."

By allowing inflation that is "higher than 2 percent for a time," inflation-adjusted short-term interest rates would fall, presumably moving real interest rate close to their market-clearing levels.

President Evans contemplates implementing the price-level targeting approach for "the duration of the liquidity trap episode," after which the Fed's objective would revert to a straight inflation target. Many believe a permanent price-level targeting approach, however, has a lot to recommend itself as an ongoing policy framework. The case 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.

Consider, for example, an annualized inflation target centered on 2 percent, with 1 percentage point tolerance range on either side of that target. This approach would be similar to the policy framework of the Bank of England, which describes the 1 percentage point tolerance level this way:

"A target of 2% does not mean that inflation will be held at this rate constantly. That would be neither possible nor desirable. Interest rates would be changing all the time, and by large amounts, causing unnecessary uncertainty and volatility in the economy. Even then it would not be possible to keep inflation at 2% in each and every month. Instead, the MPC's [Monetary Policy Committee] aim is to set interest rates so that inflation can be brought back to target within a reasonable time period without creating undue instability in the economy."

That flexibility would inevitably be a part of any reasonable inflation-targeting approach, but it comes at a cost. Because the hypothetical objective does not preclude the rate of inflation running as high as 3 percent or as low as 1 percent for a string of several years, the acceptable variation in the price level grows as time expands:


Of course, a price level growing at 2 percent annually is exactly the same as a 2 percent inflation target if the target is hewed to too consistently. And that seems to be exactly the story of U.S. monetary policy over the past 15 years.

The following chart shows the growth of the PCE price index since 1995 (the blue line), shown with a hypothetical 2 percent price level target (the green line). The upper and lower red lines represent hypothetical tolerance limits (set to two standard deviations of the actual PCE price series over the period since 1995).


I have a couple of observations to make here:

One observation is that I chose the year 1995 to start the chart above because it roughly corresponds to that last major break in the U.S. inflation trend. This timing is also near the beginning of the period when the notion that Fed policymakers had in mind an inflation goal near 2 percent became conventional wisdom.

Although the upper and lower limits of the hypothetical price level target were, in a statistical sense, chosen to bracket most of the actual path of the price level, the bounds are quite tight: The price level has almost always been within 2 percentage points of the implicit 2 percent growth path. If you still wonder why inflation expectations have appeared so remarkably stable even in light of the impressive amount of monetary stimulus applied over the course of the past several years, part of the answer may well be in the chart above. In fact, if in January 1995 you bet that the PCE price level would be within 30 basis points of a target 2 percent price level path as of August 2010, congratulations. You're in the money.

A second observation is that President Evans presents his case for allowing some pick-up in the inflation rate by noting that the current price level would be low relative to a 2 percent target implemented as of the beginning of the past recession (December 2007). As the second chart makes clear, where the current price level is relative to a long-run path is clearly dependent on the starting point. If the initial conditions for the price-level target path were chosen well in the past, it would not necessarily be the case that the price level would be sitting well below the target.

To some, that observation might weaken the case for a permanent price-level targeting framework, as it would seem to remove some of the justification for a higher short-term inflation path that would assist in generating desirable short-term real rates when the zero nominal bound problem is in play. But as the chart above illustrates, a price-level target with reasonable tolerance bounds is quite capable of accommodating the sort of inflation outcomes that President Evans suggests will assist in promoting the recovery.

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. Here's Jim Hamilton:

"Although communicating from the beginning what the exit strategy from the price targeting is supposed to be in specific quantitative terms might seem attractive, I worry 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."

Some potential benefits of simply sticking with a price-level target is that it (a) is clearly consistent with longstanding Federal Open Market Committee (FOMC) behavior (as attested to by the second chart above); (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).

In a speech earlier this week, Atlanta Fed President Dennis Lockhart offered this view:

"I am also open to a move that I believe would strengthen the effect and compensate for potential risks of the policy action [another round of quantitative easing]—that move is the adoption of a more explicit inflation objective by the committee. I believe doing so might serve as a further step to ensure the anchoring of public expectations about long-term inflation and the response of the FOMC to adverse price developments. I consider a more explicit inflation target as something the public could easily understand, and I believe it would reduce uncertainty at a time when it is badly needed."

Making that "explicit inflation objective" a price-level target is an option some believe is worth considering.

By Dave Altig, senior vice president and research director at the Atlanta Fed

October 20, 2010 in Federal Reserve and Monetary Policy , Inflation | Permalink


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I wonder if the Fed could successfully cause people to use their pronouncements, as opposed to the actual inflation experience, when forming their inflation expectations. Especially since the Fed tends to use inscrutable language in their pronouncements.

Posted by: don | October 20, 2010 at 08:21 PM

Our excessive rates of inflation (especially since 1965), has been due to an irresponsibly easy monetary policy. Our monetary mis-management has been the assumption that the money supply can be managed through interest rates

Between 1965 and June of 1989, the operation of the trading desk has been dictated by the federal funds “bracket racket”. Even when the level of non-borrowed reserves was used as the operating objective, the federal funds brackets were widened, not eliminated.

Ever since 1989 this monetary policy procedure has been executed by setting a series of creeping, or cascading, interest rate pegs.

This has assured the bankers that no matter what lines of credit they extend, they can always honor them, since the Fed assures the banks access to costless legal reserves, whenever the banks need to cover their expanding loans – deposits.

We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.

The effect of tying open market policy to a fed Funds rate is to supply additional (and excessive, & costless legal reserves) to the banking system when loan demand increases.

Since the member banks seldom operated with any excess reserves of significance (since 1942), the banks have to acquire additional reserves to support the expansion of deposits, resulting from their loan expansion.

Apparently, the Fed’s technical staff either never learned, or forgot, how Roosevelt got his “2 percent war”. This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2 -1/2 percent, and all other obligations in between.

This was achieved through totalitarian means; involving the control of total bank credit and the specific rationing of that credit we had official price stability and “black market” inflation.

The production of houses and automobiles was virtually stopped, and credit rationing severely reduced the demand for all types of goods and services not directly connected to the war effort. This plus controls on prices and wages kept the reported rate of inflation down.

Financing nearly 40% of WWII’s deficits through the creation of new money laid the basis for the chronic inflation this country has experienced since 1945. Interest rates, especially long-term, would have averaged much higher had investors foreseen this inflation. This was reflected in the price indices as soon as price controls were removed.

There were recently 5 interest rates (ceilings tied to the Primary Credit Rate @.50%), that the Fed could directly control in the short-run; the effect of Fed operations on all other interest rates is still INDIRECT, and varies WIDELY over time, and in MAGNITUDE.

It is an historical fact. The money supply can never be managed by any attempt to control the cost of credit (i.e., thru interest rates pegging governments, or thru "floors", "ceilings", "corridors",
"brackets", etc). IORs exacerbate this operating problem. I.e., Keynes's liquidity preference curve is a false doctrine.

Instead, target the price-level.

Posted by: flow5 | October 20, 2010 at 08:44 PM

Wouldn't it be a lot easier if we let the markets determine interest rates? Meaning, the Fed no longer manipulates rates in any way. Is it a fair statement that the markets are infinitely better at determining rates than the FOMC? Why do 98% of economists today argue constantly about what the Fed should do with rates, instead of debating whether it should continue to be controlled? The same, predominant economic theory that continues to make suggestions on what needs to be done, is the same theory that put us in this position. I look forward to everyone's reply.

Posted by: The Albatross Avenger | October 27, 2010 at 05:08 PM

First, this is an excellent blog by Dr. Altig which discusses in an intelligent and open fashion a policy alternative which speaks to a pressing issue of the day. To raise this issue in an open forum is gratifying and invites comment.

Second, President Evans' suggestion should be adopted.

As described, price targeting has two aspects. First, it is an operational goal by which to determine whether the Fed is meeting its target. Second, it is a method of inducing economic activity by increasing expectations in a time of economic uncertainty.

We continue to face deflation in many segments of the economy. Deflaton is pernicious in discouraging businesses to invest in new undertakings, because they weigh carefully the risk that price drops could wipe out the best planning and care. Keynes wrote an essay in August, 1931, entitled, "The Consequences to the Banks of the Collapse of Money Values." He correctly observed that banks had become content to await better times to make loans, with "...a very adverse effect on new business. For the banks, being aware that many of their advances are in fact "frozen" and involve larger latent risk than they would voluntarily carry, become particularly anxious that the remainder of their assets should be as liquid and as free from risk as it is possible to make them. This reacts in all sorts of silent and unobserved ways on new enterprise. For it means that the banks are less willing than they would normally be to finance any project which may involve the lock-up of their resources." P.173, Essays on Persuasion. This certainly fits the situation today in the American economy.

A way to discourage this conduct by banks is to create the anticipation of a target inflation and then the fact of an achieved target inflation. Business planning becomes easier and banks have less to fear if the collateral they hold appreciates---modestly.

As to fear of the "infamous graph", the answer is to not make a graph and to emphasize that the Fed is not guaranteeing that these targets can always be achieved. Most people that understand the economy at all would understand that point.

Given how unlikely it is, on account of the election results of November, 2010, that there will be any fiscal stimulus through the creation of direct, increased government demand, it is time to do what can be done to ease the "liquidity trap."

The Fed is fortunately not tied to the electorate, by virtue of insightful design at its origin. The Museum in the Atlanta Fed's lobby has examples of Zimbabwe's hyper-inflation currency. For those inclined to more distant history, there is a real German mark from the 1920's , bearing a blue ink stamp affixed after the note's original printing, increasing its face value many, many fold. These exhibits are chilling reminders of the opposite evil of deflation. The Fed understands all of this and will not lead us to either extreme, an economy choked down by deflation or made inoperable by run away nominal values.

Posted by: mme | November 07, 2010 at 09:41 PM

I am no monetary expert, but wouldn't price level targeting only fuel more economic uncertainty and instability? My point is that if one year it's inflation on then inflation off won't capital flows be highly volatile across a bunch of different asset classes? Furthermore, isn't the majority of the deflation occurring now a result of decreasing costs, increased productivity and economies of scale among businesses of all types? For the last 3 decades or so employers have plowed money into IT, process improvement, and efficiency and now they have it. I say falling prices among consumer goods are a godsend to the American consumer. Falling financial asset prices are a terrible thing, but that is not really happening. I guess I am lost on why the FED is trying to reinvent the wheel. Every crisis need not carry with it economic experimentation.

Posted by: ShaunP | November 16, 2010 at 01:39 AM

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