Asymmetric Credibility at the Fed and Price-Level Targeting

December 30th, 2014 at 6:30 am

While we in the US don’t have the disinflation (positive but declining rates of inflation) problem facing the Eurozone, our benchmark inflation rate has consistently undershot its mark. The Federal Reserve target for the core PCE deflator is 2%, year-over-year, and yet it hasn’t hit that growth rate even once since April of 2012. Since then, the average rate of PCE core inflation is 1.5% (Euro area core inflation was last seen growing at 0.6%).

Note also that the 2% is a target, not a ceiling (though there’s often ambiguity around this), meaning if you’ve been below for a while, it’s consistent with hitting your target rate on average to be above it for a while as well.

And yet, the question of whether the Fed is adequately meeting the “stable prices” part of its dual mandate (the other part is, of course, full employment) seems almost uniformly to be whether it’s keeping inflation from going above 2%. In other words, the Fed’s inflation credibility is asymmetric: they only lose credibility points for going above 2%.

As a policy matter for a healthy economy, this is wrong, as low inflation can be just as problematic as high inflation. These days, the most common reason economists call for higher inflation is to lower the real interest rate when the federal funds rate (ffr) is stuck at the zero lower bound. Since the real interest rate equals the nominal rate minus inflation, when the ffr is about zero, the real interest rate is the negative of the rate of inflation.

Now, suppose a lower real interest rate is required in order to stimulate the investment and consumption necessary to close the existing gaps in output and employment. At the ZLB, the central bank’s main tool is shot. Thus, higher inflation is the key that can unlock the economy from the liquidity trap.

There are reasons to doubt this logic. For one, the secular stagnationists, whose insights I’ve generally applauded, too often make it sound like if only the real interest rate were -3.5% instead of -2% (or something like that), everything would be fine. Surely, given all the other factors holding back demand, from trade imbalances to the unequal distribution of growth to fiscal drag and more, that’s too facile. Second, how confident should we be in the embedded assumption, rarely discussed, that the Fed can actually move inflation around at will?

Still, I certainly agree with the thrust of the argument re the need for higher inflation and in my calculus, the Fed loses the same credibility points for undershooting as overshooting. So what should/could the Fed do to at least hit their inflation target, if not raise it to a higher number? There’s extensive literature on this, insightfully reviewed here by David Beckworth.

One simple idea worth considering is not inflation targeting—the Fed’s current approach—but inflation level targeting. The difference is that you target the price level such that if you undershoot in one period, you’ll need to overshoot later to make up the loss. That’s different than the current approach, where “past mistakes and shocks are treated as ‘bygones’” (see Hatcher and Minford’s on-point discussion of level targeting).

See the figure below. Let’s say, starting at the peak of the last business cycle (Dec07), the Fed decided that the price level should increase 2% every year. Setting the level to 100 in Dec07, it should be 102 a year later, 104.04 (102*1.02) a year after that, and so on. Under this target, if the Fed undershoots the target in year 1, they have an explicit mandate to goose prices next year to catch up.

pce_level

Source: BEA, my analysis.

The punchline is that under price-level targeting, when the Fed undershoots the target level, expectations are for higher inflation next year, which lowers the expected real interest rate, and voila, you’re less vulnerable to ZLB problems. At least that’s the theory.

The top line in the figure shows the path under level targeting, or what the price level of the core PCE would be if it actually grew 2% per year. The other line shows what actually happened, and the difference today is about 4%.

There’s an implicit assumption in all of this that once it’s truly committed to doing so, the Fed can credibly hit the level target. In fact, a lot of the writing on this seems pretty circuitous to me. The usual rap goes like this: “the reason the Fed can’t raise either inflation or inflationary expectations is because everyone knows they’re not really committed to doing so. Even if they said, ‘we declare inflation should be 3%!’ everyone would know they really want it to stay at 2%, so neither inflation nor expectations would change.”

This assumes that if they really, truly did want to get prices up to 3 or 4 percent, they could do so. I’m not so sure. They’ve certainly been hard pressed to hit their 2% target so why should we assume they could accurately target either a different level or rate? To be clear, this is no rant against the Fed, who have consistently and admirably been the only game in town trying to close the gaps that still persist. And I’m quite confident they can slow growth and thus inflation by tightening.

But globalization of both goods and capital have significantly reduced supply constraints and I wonder just how much sway the Fed has over prices these days. The Phillips curve seems awfully flat and while that’s partly “well-anchored expectations,” I suspect extensive global supply chains are part of that story as well.

So put me down as all-in for the Fed targeting the price level as opposed to just the rate, as insurance against the ZLB, which is less rare and more damaging than many economists and policy makers imagine. But I’ll believe its effectiveness when I see it.

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4 comments in reply to "Asymmetric Credibility at the Fed and Price-Level Targeting"

  1. dwb says:

    I am not sure there is a real distinction between price level targeting and Sumner’s nominal income (level) targeting. I think either would get the job done.

    My fundamental issue with both inflation and price level targeting is the choice of target or price level. Most of the literature I’ve read on inflation targeting assumes an inflation/price level target of domestic goods or GDP deflator. This is important! The Fed can only control domestic inflation (as you note: “globalization of both goods and capital have significantly reduced supply constraints and I wonder just how much sway the Fed has over prices these days.”).

    I am not a fan of the PCE as inflation target, a more stable choice would be one without import goods prices, which the Fed cannot control. Of course if we used the GDP deflator (which would be my preference), then we are a hairs difference from NGPLT (Sumner’s proposal).

    Of course, you could argue that a rise in oil prices really are inflation, and you would not be wrong. But including import goods prices means the Fed responds to rising oil prices by creating mass unemployment.


  2. Zach Davis says:

    “Second, how confident should we be in the embedded assumption, rarely discussed, that the Fed can actually move inflation around at will?”

    Given that the Fed has managed to add $4 Trillion in liquidity to the balance sheets of their trading banks in the way of excess reserves without causing massive inflation, I would think it’s very clear that they can do just this… of course “at will” in terms of monetary policy is speaking in 3 to 4 year terms in this case.

    The key factors to consider in all of this are the discount rate (the rate the Fed lends reserves for) and the rate of interest that they pay on reserves (a power granted to them in 2008). These provide the floor and ceiling for the federal funds rate, which in turn provides the targeting mechanism for inflation.

    I agree in principle, though, that pundits and market makers do not have an appetite for inflation above 2%.


  3. Smith says:

    Is there really no one who has thought to ask whether 2% is the ceiling or average?
    http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20141217.pdf
    Yellen states “But it’s important to point out that the committee is not anticipating an over-shoot of its 2 percent inflation objective.”
    This doesn’t sound ambiguous, it just sounds wrong, as though 2% was a ceiling and averages were not considered, let alone cumulative price levels.
    I would like to state that 2% is idiotic, but that would imply Yellen is an idiot, and either way, she’s probably the smartest person in the room.
    When somebody finally gives a list of at least the few or several, maybe 3 to 10 conditions, that are valid inputs into determining an acceptable inflation target, and then lists the corresponding targets, and of course ends the nonsense about treating a targeted average as a ceiling, then we can talk.

    I would also like to note the dangerous ability of businesses to arbitrarily control prices which threatens price stability in a moderate inflation environment, whether caused by commodities or labor markets. There are mechanisms that could counter this effect, by encouraging competition, enforcing and strengthening anti trust laws, regulating natural monopolies, using leverage of government and labor to affect corporate governance, changing tax laws to discourage profits and better reward capital and human investment. This is another key to allowing above 2% inflation, which is unfortunately ignored by all those who be surprised if labor ever made gains which were then repeatedly wiped out and exceeded by rising prices.


  4. David Beckworth says:

    Jared, thanks for the mention. I too address the question of the price level targeting in a more recent post here: http://macromarketmusings.blogspot.fr/2014/12/tinkering-on-margins.html It speaks to why a level target is needed in a ZLB depression rather than a growth rate target.

    Smith, yes, I think there is compelling evidence the Fed is targeting a 2% upper bound. See the link above in my comments to Jared.


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