The Federal Reserve plans to review its inflation growth rate target and potentially select a new monetary policy target. Many Fed officials are in favor of the idea, including Chair Powell. And the latest FOMC minutes show that the Fed’s policy setting committee has discussed new targets.
This is good news, because inflation rate targeting suffers from serious shortcomings. With a growth rate target, a central bank writes off past errors. Instead of deliberately correcting those errors, it “lets bygones be bygones,” allowing its mistakes to permanently alter the value of its policy target. For example, the Fed has persistently undershot its 2% inflation target since adopting it in January 2012. Because it does not plan to atone for this prolonged period of undershooting the price level will forever remain below its original target path, at least so far as deliberate Fed actions are concerned.
Successful price level targeting requires, on the other hand, that the central bank make up for past mistakes. Monetary policy is successful if the price level returns to the trend line it was growing along before the undershooting occurred. This makes the future course of the price level easier to predict. Inflation growth rate targeting cannot match this degree of predictability because its policy errors permanently change the long run price level, making the future path of the price level more like a random walk.
Improved price level predictability is one of the reasons that several Fed officials have discussed the benefits of adopting a price level target. For example, John Williams, who will take over as President of the New York Fed and become Vice Chair of the FOMC next Monday, argues that a price level target would offer an increased level of predictability over inflation rate targeting by better indicating where prices will be 5, 10, even 30 years into the future. Williams also believes, rightly, that this predictability would make future Fed policy more transparent to the public.
Richard Clarida, Vice Chair-elect at the Federal Reserve Board, has also suggested implementing a price level target. He made the suggestion back in 2014 because he was concerned that the Fed lacked the ability to credibly communicate the future path of policy absent a level target. At the time, the Fed was following the Evans Rule, a promise to leave interest rates at the zero lower bound until either inflation was above 2.5% or the unemployment rate was below 6.5%. Clarida saw that these thresholds were not enough to anchor the public’s expectations going forward. He feared that so long as the public’s expectations remained insufficiently anchored, the Fed would continue to struggle to meet its policy target.
In his most recent speech, the Atlanta Fed’s new President, Rafael Bostic, also endorsed a price level target as an alternative to the Fed’s current inflation rate target. Like Williams and Clarida, Bostic believes that price level targeting would have performed just as well as inflation rate targeting throughout the Great Moderation, and that it would have been superior to it since the Fed adopted an explicit inflation target in 2012.
While Fed officials are right to believe that price level targeting can improve upon inflation rate targeting, they fail to consider the shortcomings of either alternative in the presence of supply shocks. A price level target (to refer only to the better of these two options) may be optimal in the absence of such shocks, but in their presence it makes monetary policy procyclical.
Consider the case of a negative supply shock. A sudden fall in the global production of oil would likely push up domestic gas prices, which would in turn raise the price level. Such a rise would be a signal to the Fed to tighten monetary policy. Yet, tighter monetary policy would provide no relief to the economy in such a circumstance. Tighter policy would put further downward pressure on an economy whose consumers already feel constrained by higher prices because of the oil shock. Only if the rise in gas prices was the result of excess aggregate demand, something likely caused by over-easing by the Fed, would tighter monetary policy be appropriate.
Positive supply shocks can likewise have procyclical consequences. Were the United States to see a (welcome) improvement in productivity the inflation rate would tend to fall. After a short period with the lower inflation rate the price level would still be rising but be below its target path. Under a price level target, the Fed would respond with easier monetary policy in an effort to raise the inflation rate and bring the price level back up to its path. But prices falling because products are made more efficiently is a gain for consumers, who ought to enjoy lower prices on those products. Trying to raise the overall price level in an effort to “combat” these productivity gains should hardly be part of a central bank’s policy and could risk overheating the economy.
In short, the tendency of a price level targeting central bank to respond to positive supply shocks in the same way as it responds to negative demand shocks, and to respond to adverse supply shocks in the same way as it responds to positive demand shocks, is a recipe for trouble. To their credit, both Bostic and Williams discuss implementing a “flexible” price level target, one that could be adjusted to changing economic circumstances. Such flexibility would allow the Fed, at least in theory, to avoid procyclical monetary policy during supply shocks by allowing the price level to change.
But flexible price level targeting is really just a more ad-hoc, and therefore less robust, version of a nominal GDP level target. Nominal GDP is the overall size of the economy uncorrected for inflation, so nominal GDP growth is essentially the sum of the real growth rate and the inflation rate. Under a nominal GDP level target the central bank would be stabilizing overall spending, thereby automatically and systematically doing what flexible price level targeting is supposed to accomplish with less risk of implementing procyclical monetary policy.
Reconsider the previous example when the inflation rate tends to fall during periods of improved productivity, except now the central bank has a nominal GDP level target. With the inflation rate falling the price level would fall below its previous trend, but that decline would not elicit any procyclical response from the central bank. Under a nominal GDP level target the central bank only responds velocity shocks. The central bank would adjust the money supply to offset velocity shocks, in an effort to stabilize overall spending and keep nominal GDP growing on its trend.
Because it focuses the central bank’s response function on one variable, changes in velocity, a nominal GDP level target is the best target for monetary policy. On the other hand, a price level target, and its advocates fail to fully account for this, obligates the central bank to react to changes in velocity and changes in aggregate supply. A nominal GDP level target offers the same degree of predictability as a price level target, but has the additional advantage of being robust to supply shocks, precisely because it allows the price level to change. Under a nominal GDP level target, the chances of the Fed being procyclical during a downturn and amplifying the contraction would be greatly reduced.
Price level targeting proponents are right to believe that it is superior to inflation rate targeting because it corrects the bygones problem, improving the Fed’s performance by making the price level more predictable. However, a price level target is the ideal only in a world without supply shocks. With supply shocks, a central bank with a price level target would too often act in a procyclical manner. A “flexible” price level target is certainly a better option than a strict price level target. But it would only be the best available option if it were so “flexible” that it amounted to nothing other than a nominal GDP level target.
Fed officials are making the right decision to rethink the current inflation rate target. For that review to be successful, they should thoroughly consider, but ultimately reject a price level target. Instead, they should listen to a growing number of economists discussing the best option: a nominal GDP level target.
[Cross-posted from Alt-M.org]