The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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January 07, 2013

Inflation versus Price-Level Targeting in Practice

In last Wednesday's Financial Times, Scott Sumner issued a familiar indictment of "modern central banking practice" for failing to adopt nominal gross domestic product (GDP) targets, for which he has been a major proponent. We have expressed doubts about nominal GDP targeting on several occasions—most recently a few posts back—so there is no need to rehash them. But this passage from Professor Sumner's article provoked our interest:

Inflation targeting also failed because it targeted the growth rate of prices, not the level. When prices fell in the U.S. in 2009, the Federal Reserve did not try to make up for that shortfall with above target inflation. Instead it followed a "let bygones be bygones" approach.

In principle, there is no reason why a central bank consistently pursuing an inflation target can't deliver the same outcomes as one that specifically and explicitly operates with a price-level target. Misses with respect to targeted inflation need not be biased in one direction or another if the central bank is truly delivering on an average inflation rate consistent with its stated objective.

So how does the Federal Reserve—with a stated 2-percent inflation objective—measure up against a price-level targeting standard? The answer to that question is not so straightforward because, by definition, a price-level target has to be measured relative to some starting point. To illustrate this concept, and to provide some sense of how the Fed would measure up relative to a hypothetical price-level objective, we constructed the following chart.

Consider the first point on the graph, corresponding to the year 1993. (We somewhat arbitrarily chose 1993 as roughly the beginning of an era in which the Fed, intentionally or not, began operating as if it had an implicit long-run inflation target of about 2 percent.) This point on the graph answers the following question:

By what percent would the actual level of the personal consumption expenditure price index differ from a price-level target that grew by 2 percent per year beginning in 1993?

The succeeding points in the chart answer that same question for the years 1994 through 2009.

Here's the story as we see it:

  1. If you accept that the Fed, for all practical purposes, adopted a 2 percent inflation objective sometime in the early to mid-1990s, there arguably really isn't much material distinction between its inflation-targeting practices and what would have likely happened under a regime that targeted price-level growth at 2 percent per annum. The actual price level today differs by only about 0.5 to 1.5 percentage points from what would be implied by such a price-level target.

    Hitting a single numerical target for the price level at any particular time is of course not realistic, so an operational price-level targeting regime would have to include a description of the bounds around the target that defines success with respect to the objective. Different people may have different views on that, but we would count being within 1.5 percentage points of the targeted value over a 20-year period as a clear victory.

  2. If you date the hypothetical beginning of price-level targeting sometime in the first half of the 2000s, then the price level would have deviated above that implied by a price-level target by somewhat more. There certainly would be no case for easing to get back to the presumed price-level objective.

  3. A price-level target would start to give a signal that easing is in order only if you choose the reference date for the target during the Great Recession—2008 or 2009.

We're generally sympathetic to the idea of price-level targeting, and we believe that an effective inflation-targeting regime would not "let bygones be bygones" in the long run. We also believe that the Federal Open Market Committee (FOMC) has effectively implemented the equivalent price-level target outcomes via its flexible inflation-targeting approach over the past 15 to 20 years (as suggested in point number 1 above).

In fact, the FOMC has found ample scope for stimulus in the context of that flexible inflation targeting approach (which honors the requirements of the Fed's dual mandate of price stability and maximum employment). We just don't think it is necessary or helpful to recalibrate an existing implicit price-level target by restarting history yesterday.

Dave AltigBy Dave Altig, executive vice president and research director and

Mike BryanMike Bryan, vice president and senior economist, both of the Atlanta Fed

January 7, 2013 | Permalink


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"Misses with respect to targeted inflation need not be biased in one direction or another if the central bank is truly delivering on an average inflation rate consistent with its stated objective."

is exactly equivalent to saying that a random walk is not biased up or down. That's certainly true, but it's also true that E(X[t+k] - X[t])^2 = k. When you target the first difference of the price level rather than the price level itself, the forecast error for the optimal forecast is going to be a random walk. You get much smaller forecast errors going out if you target the price level.

It's also a whole lot easier to explain to the public. If you say "we're going to target high inflation now because it was low earlier" that will sound fishy to most people. But if you put it as "The CPI is running below our target path recently, so we're going to bring it up to the target" it doesn't feel quite so much like you're trying to pull a fast one.

I wonder if you've seen the Mishkin and Woodford piece in the Wall Street Journal yesterday. There's still plenty of room in the NGDP level target bandwagon, but it's filling up fast!

Posted by: Jeff | January 07, 2013 at 04:09 PM

Michael Woodford is now explicitly endorsing an NGDP level target.

Posted by: Jeff | January 07, 2013 at 04:20 PM

I think the chart is deceptive. During most of this period, indeed until January 2012, when the Fed adopted an explicit inflation target, the perception was that the Fed was targeting core inflation. My impression is that the shape of this chart is driven mostly by oil prices (falling in the 1990's and rising in the mid 2000's, hence the chart's bulge in the intervening period), which would be irrelevant if the core PCE deflator, rather than the headline, were the target. According to my calculations, rather than, as this chart implies, having overshot the target relative to the early 2000's, we would be undershooting the target on a core PCE deflator basis. Comparing PCEPILFE (from FRED) for Nov 2012 to Nov 2003, I get an increase of 18.4%, compared to the 19.5% increase that would be implied by an annual increase of 2%.

Now, one might (though I think it would be a bad idea) choose the headline index as a price level target going forward, perhaps using January 2012 as a base date, since the perception since then has been that there is a headline target. But it makes no sense to apply that price level target retroactively to a period when the perception at the time was of a core target.

In any case, as I said, I think the headline PCE deflator is a bad price level target. If you're going to use a price level target (and I do think it would be better than an inflation target), then you don't want to use a price index that will be subject to shocks that are volatile but persistent. A one-time increase in the price of oil should not require a subsequent compensating decline in other prices to offset it (nor should a one-time decrease in the price of oil require a subsequent burst of inflation to offset it). Theoretical arguments would suggest using an index of sticky prices, but the core is a reasonable approximation.

I think Sumner's argument goes through pretty much unscathed if you think in terms of core prices.

Posted by: Andy Harless | January 07, 2013 at 06:27 PM

David & Mike,

You refer back to your previous post on NGDP level targeting, but fail to take note of the comments that respond to your concerns about it. Specifically, see the ones by Andy Harless and Gregor Bush. Would love to see your response to those ones. Do you have a response for them? I am listening if you have one.

Posted by: David Beckworth | January 07, 2013 at 07:18 PM

In all the hooha about monetary policy (MP)targets and poor response from fiscal policy (FP), nobody has mentioned what fiscal policy should be targeting? Ideally, MP and FP should work together. Why not have FP targeting NGDP?

Posted by: Oupoot | January 08, 2013 at 04:25 AM

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