The Federal Reserve’s war against falling inflation continues.
The latest from the Wall Street Journal’s Fed-watcher Jon Hilsenrath:
Charles Evans, president of the Federal Reserve Bank of Chicago, called for the Fed to do more to charge up the economy, including a new program of U.S. Treasury bond purchases and possibly a declaration that it wants inflation to rise for a time beyond its informal 2% target.
“In the last several months I’ve stared at our unemployment forecast and come to the conclusion that it’s just not coming down nearly as quickly as it should.”
“This is a far grimmer forecast than we ought to have,” he added. As result, he said, he favors “much more [monetary] accommodation than we’ve put in place.”
So far, so QE2.
But later in the article Evans — who doesn’t have a vote on US monetary policy but supposedly represents the centre ground at the Fed — goes on to talk about the idea of ‘price-level targeting.’ This means targeting an actual index level as opposed to targeting an annual rates of inflation. Here’s the basic idea:
The idea espoused by Mr. Evans and Mr. Dudley [New York Federal Reserve Bank President William Dudley] is known as “price-level targeting.” Inflation is measured as the change in the consumer price index or other price indexes. Rather than target an annual inflation rate of 2%, the Fed would target an inflation index level. So if the consumer price index fell short of the level the Fed targeted one year, it might get back to that level the next year by overshooting a little. It could be a challenge for the Fed to explain such a strategy, and to convince the public that it wouldn’t allow inflation to get completely out of hand.
Spot on, Hilsenrath. Just think of the implications of such a move.
But, if you can’t, this note from RBS’s John Briggs and Bill O’Donnell spells it out:
Think of it this way: If the level of their targeted index is 100 now, the Fed will say it wants the inflation level to be 108.25 (back of the envelope, a 2% rate per year for 5 years). The Fed will then leave extraordinary accommodation in place until the index reaches that level, however long it takes. If the market (private forecasters, etc) does the math and realises that it will take longer than 5yrs to achieve this level (for example the path for inflation is 1% a year or similarly too low to reach this target), it will crush term premiums out the curve. If the Fed will not raise rates for 6 years, where should 5yr notes be?
Five years!
But wait, inflation targeting does have a champion:
“What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.)
“A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation. “
Those excerpts were from a speech given by one Ben Bernanke to the Japan Society of Monetary Economics in 2003.
Related links:
Jan Hatzius’ US economy Q&A – The Long Room
From the FOMC, to markets, with love – FT Alphaville
QE wars, Japan edition – FT Alphaville