We’ve written in some detail about price-level targeting and how it would differ from targeting the inflation rate — and also about our frustration with Ben Bernanke’s refusal to discuss it despite some support for the idea from within the FOMC.
This week’s Economist has an article looking more closely at the drawbacks of price-level targeting that’s worth looking into a bit more for what it says about quantitative easing as a whole — especially given that this Wednesday is, well, you know what.
The article starts with a good summary of why price-level targeting is attractive:
In theory price-level targeting is superior to inflation-targeting because it provides more certainty about the long-term purchasing power of money. Central banks always target inflation flexibly. The Bank of Canada and the Bank of England, for example, target a rate of 2% but permit a range of 1% to 3%. That means someone making a 30-year investment must plan for cumulative inflation of as much as 143% or as little as 35%. A credible price-level target eliminates that uncertainty.
This is consistent with the paper by NY Fed economist Gauti Eggertsson that we discussed last week, which concluded that price-level targeting is more effective at managing people’s expectations of future inflation and real interest rates — and of mitigating the distortions created by periods of disinflation or deflation.
As to why price-level targeting might be a bad idea, here is The Economist again:
It would require a central bank repeatedly to alter its goal for future inflation as prices deviated from the desired path. This could befuddle a public long accustomed to thinking in terms of inflation rather than price levels. There are questions, too, about how central bankers would deal with a one-time rise in the price level because of a new value-added tax, say, or higher oil prices. The boost to inflation would be temporary, but to the price level, permanent. In theory a central bank would have to wrestle all other prices lower no matter what the cost. It could make an exception, but too many exceptions would dent the bank’s credibility. Conversely, a positive shock such as lower oil prices or higher productivity that pushes prices lower would require the central bank to raise future inflation, driving down real interest rates and maybe risking an asset bubble.
All good points, and as for Bernanke’s own thoughts, it is likely the period during which the inflation rate would have to be above 2 per cent (while it catches up to the targeted price level) that bothers him — his public statements this year suggest that he worries this would threaten the bank’s credibility.
It’s also worth bearing in mind that either kind of target — whether to the inflation rate or to the price level — would limit the Fed’s discretion and could force it into a decision later where it would have to choose between sticking to the target, as pledged, or abandoning it to fix an immediate problem (again, damaging its credibility). Perhaps targeting NGDP would be better, as David Beckworth argues, but we’ll leave that for another time.
But it’s what The Economist says next that really gets our attention:
By far the biggest question is whether price-level targeting would actually work, and that depends critically on how people form inflation expectations. The more they look ahead, basing their views on economic conditions and the central bank’s policy, the more effective price-level targeting becomes, since inflation expectations would adjust more easily to the central bank’s shifting target. If people look backwards, however, and base their expectations on where inflation has been in the past, price-level targeting loses effectiveness: getting inflation expectations up will rely on getting inflation itself up, a chicken-and-egg dilemma.
One of the big premises of QE is that raising medium-term expected inflation (lowering expected real interest rates) will lead businesses and consumers to start spending their money.
But we wonder how much anybody really knows about how economic policy can effectively influence the way people form inflation expectations. To us this seems like murky, animal spirits-ish sociological territory. Not that a central bank can’t influence expectations — indeed it has worked before — but the process is highly uncertain.
Here’s Mark Thoma explaining part of the problem:
It seems to me that everyone fighting today over whether QEII will work are worried about whether the Fed can affect real rates, but are forgetting about the second step in the process. Once real rates rates fall, firms and households then have to be induced to borrow more, then consume or invest (I’m including the response to expected inflation in this). Even if we manage to change real rates, and I have never quarreled with the Fed’s ability to do this (though the extent depends upon their ability to affect expectations), why do people think it will bring about a strong consumption and investment response in the current environment?
We (or at least this correspondent) simply have no idea what’s going to happen next, or even whether another big round of quantitative easing is a good idea. We do know that price-level (or NGDP targeting) would be a bold measure indeed, just as implementing a ceiling on Treasury yields would be. But as the Fed has been contemplating a measured approach for today, we’re not expecting such audacity this time round.
Related links:
Beyond QE2 – to central bank credibility – FT Alphaville
When strange things happen at the zero lower bound – FT Alphaville