Friday, January 21, 2011

This is a guest post from Hunter Richards, who blogs about online accounting software and other business technology for Software Advice. This article was originally published on Hunter's blog here.

Despite the tremendous benefits of information technology (IT), it comes at a human cost - the displacement of less-skilled employees. As software and systems automate an increasingly large portion of business processes, the displacement is affecting a wider set of workers. So despite an improving economy, 9.5% unemployment might last longer than many think.

Here we walk through a fairly simple story of man versus machine. It’s not a new story, but we went to the effort of pulling together and visualizing the relevant data.

Looks like it's time to hit the books.

IT spending has risen dramatically over the last 40 years...

Rise in IT Expenditures

IT spending has steadily risen since 1970. Trendlines and new opportunities like cloud computing suggest that the current dip in spending is only temporary.

...making us more productive...

Productivity on the Rise

Technology has made labor more productive. There’s a long-term upward trend in labor output rates, and it isn’t slowing down.

...which has led to rapid growth in corporate profits.

Growth in Profits

The resulting productivity has been great for business - greater productivity means higher profits. But these profits don’t benefit everyone. They accrue to the executives and shareholders.

IT is slowly replacing many functions. There’s an ever-widening divide in the labor market between skilled occupations and what one might call “low-level jobs” - simple clerical roles, plant-floor workers, and low-level support roles.

While national unemployment rates have ebbed and flowed...

National Unemployment Rate

...the uneducated are consistently left behind...

Education and Unemployment

This polarization between highly-skilled and less-skilled workers is part of what’s eroding the middle class, pushing more and more people into the low income bracket.

...and wealth has shifted toward the highest earners.

Income Gaps Over Time

The less-educated workers who manage to keep their jobs are falling further and further behind in the national income distribution as the relative value of their services declines.

Alas, high-tech industries are growing...

Tech Pulse Index

So how can you avoid being replaced by a machine? You’ll need to be one of the people who work in an advanced field that still requires highly-skilled human capital. Take the IT field, for example. The Tech Pulse Index tracks the growth of national economic activity in technology by combining data on employment, investment, production, shipments, and consumption. The Tech Pulse Index has risen sharply (with the exception of the dot-com bust around the year 2000), reflecting continued demand for high-tech workers. The same is true in other engineering disciplines, healthcare and finance.

...but an advanced education is required.

Education Enrollment Rates

Are we educating people enough to slow the widening of labor market gaps? The graph above shows the percentage of all 18- to 24-year-olds enrolled in degree-granting institutions since 1970. There’s an upward trend, but is it growing fast enough?

IT is good for society in the long term, but it’s a double-edged sword when considered together with labor market trends. Sure, the current economic despair owes its severity to many different issues - offshoring of jobs, the real estate collapse, and the national debt are just a few - but education and income disparities are long-term problems that demand attention. We must align education growth with productivity growth to close these gaps.

Thursday, January 13, 2011

Janet Yellen and the Fed's New Approach to Asset Bubbly

     I love Janet Yellen because she is an academic and a Hyman P. Minsky follower on the Federal Reserves Board of Governors.  In a recent speech titled "The Federal Reserve's Asset Purchase Program", Yellen breaks down the Fed's decision to engage in a second round of asset purchases while offering the best research available.  She delves into the beverage curve- which is the relationship between unemployment and job vacancies- to talk about both structural and cyclical factors affecting unemployment.  Additionally, she details the Fed's new attempts at monitoring quantitative easing effects on credit flows and asset bubbles.  This is a revolutionary and remarkable change in procedure at the Fed because before this crises the Fed would have completely denied looking at asset price movements and credit in making its decisions.  This signals a significant shift in the attitude and mindset that recognizes that markets are not always efficient or rational, especially when it comes to asset prices.  In evaluating the dangers of the Fed's latest round of quantitative easing, Yellen mentioned the following asset price and credit indicators:

With respect to the stock market:
"In the stock market, for example, price-to-earnings ratios, by some measures, remain below their averages over the past several decades, and other valuation measures also indicate that equity prices are not significantly out of alignment with past norms."
Then looking at the Price-to-rent ratio for the housing market:
"In the real estate market, price-to-rent ratios for both residential and commercial real estate are now within a reasonable range of their long-run averages, in contrast to the severe misalignment that occurred prior to the crisis. Again, there is little sign here of imbalances relative to fundamentals, at least if history is used as a guide."
In the Bond market we have seen the obvious bubble created by the fed when it intervenes into the market and buys up treasuries:
"In fixed-income markets, narrow risk spreads and risk premiums could be signs of excessive risk-taking by investors, and indeed spreads on corporate bonds have dropped dramatically since the financial crisis, as the economic outlook has improved and investor sentiment has picked up. Risk premiums on nonfinancial corporate bonds, as measured by forward spreads far in the future, are relatively low compared with historical norms, although other indicators for this market do not point to overvaluation." 
Yellen even mentions identifying financial imbalances by focusing more directly on measuring credit flows and exposure to credit risk! In this area the risks are mute:
"Thus, there is little evidence that financial institutions are significantly expanding the level of credit and liquidity provided to households and businesses on net. Indeed, given the current very low level of interest rates and the continuation of the economic recovery, credit flows remain stubbornly sluggish."
The Fed even created a new survey called the Senior Credit Officer Opinion Survey on Dealer Financing Terms to monitor leverage:
"To monitor leverage provided by dealers to financial market participants, last June the Federal Reserve launched the Senior Credit Officer Opinion Survey on Dealer Financing Terms. This survey provides information on credit terms and availability of various forms of dealer-intermediated financing, including funding for securities positions and over-the-counter derivatives. The survey results suggest that over the past several months there has been some easing of terms applicable to financing for a range of counterparty types and many types of collateral, as well as an increase in demand from clients to fund most types of securities. These results indicate that the availability and use of leverage by nonbank financial institutions increased somewhat last year."
The Fed is on track to be extremely successful in the long-run.  Although, the additional asset purchases are a dangerous move given that the Fed has created and set in motion a bond bubble.  The asset purchases explicitly say to the financial markets that the Fed will not be afraid to use this tool in the future, which may in itself create a moral hazard for the bond market.  The thing that I love best about Janet Yellen's speech must be the explicit statement about using adaptive regulation to target financial imbalances versus using the extremely blunt federal funds rate.  Janet wants to work closely with other regulators to monitor systemic risk and nip asset inflation in the bud.  I wrote about this a while back (June 21,2010 to be exact)  thus making me especially delighted that someone on the board has formed the same views (albeit independently):
"We are working with other regulators to make the financial system more robust and are attentive in our supervision to developments that may affect systemic risk. If evidence of financial imbalances were to develop, I believe that supervision and regulation should provide the first line of defense so that monetary policy can concentrate on its longstanding goals of price stability and maximum employment. That said, we cannot categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause."

Friday, January 7, 2011

The Employment Situation

The employment situation is by far the most significant of all the major economic indicators.  The reasons include the data timeliness as it is literally released one week after the month being looked at and also the fact it includes data on household earnings and the job market which determines future spending.  

First thing to note is that the employment situation is broken up into two sections; the household survey and the establishment (or payroll) survey.  The household survey is essentially the government contacting 60,000 people each month, and from this data the civilian labor force along with how many of these people actually have jobs is calculated.  Furthermore, it is from the household survey that we derive the widely reported unemployment rate.  The establishment survey is considered to be a better employment measure than the household survey as its data comes directly from businesses, not households.  Each month the Bureau of Labor Statistics gets in touch with 400,000 companies and government agencies which are responsible for the employment of 40 million or so workers.  The following is a graph of total nonfarm payrolls (in thousands):
 One important thing to notice is the average number of hours worked in a week.  If the number of weekly hours increases for three consecutive months (aka the three month moving average is increasing), it is a strong signal that companies will soon accelerate hiring.  The same is true vice-versa, meaning if the three month moving average is declining then expect layoffs and cutbacks.  From the BLS employment situation report:
"The average workweek for all employees on private nonfarm payrolls
held at 34.3 hours in December. The manufacturing workweek for all
employees declined by 0.1 hour to 40.2 hours, while factory overtime
remained at 3.1 hours."
As the following graph shows average weekly hours have remained steady, indicating the economy is not going to be doing much on the hiring front:

Overtime hours are noteworthy because in times of economic uncertainty, rather than hiring new workers companies might ask their employees to work additional hours.  The catch is that overtime hours can be costly for a firm and so if there is a consistent upward trend in hours for 3 months firms are put under pressure to hire again. Changes in overtime manufacturing hours are considered particularly sensitive to fluctuations in demand. As the following graph shows over time hours have indeed increased but are still below pre-recessionary levels:

One of the best things to look at when seeking to reveal trends in future employment is temporary employment.  Companies often prefer to employ temporary help, due to lingering uncertainty I suppose, before taking the big daddy all in expensive step of permanently hiring and training new full-time employees.  Temps are cheaper and they give firms flexibility to add and reduce staff during these most certainly uncertain times.  The following graph paints the picture that firms are adding temps, but we have some time yet to see if this translates into any permanent hiring.
The source for the graph above is indeed the BLS and the data was extracted from the best site ever created- FRED.

The most recent employment situation reveals that the unemployment rate edged down to 9.4% and nonfarm payroll employment increased by a wompish 103,000 -considerably below expectations of around 150,000.  The drop from 9.8 to 9.4 in December, on the surface seems pretty great, however it may just reflect people leaving the labor force because they no longer receive unemployment benefits and consider themselves hopeless.  The WSJ real time economics blog highlights this change:
"The big drop in the overall unemployment rate and the U-6 measure was primarily due to a decline in the number of unemployed, which fell by 556,000 in December. That’s good news since the number of people who are employed increased by nearly 300,000. But that still leaves over 250,000 workers leaving the labor force altogether. That likely means a substantial part of the drop was due to workers giving up. Anyone unemployed over 99 weeks has no access to unemployment benefits and many lose access even earlier. Once those benefits expire, the unemployed may stop considering themselves part of the labor force."
Sudeep Reddy of the Wall Street Journal's Real Time Economics Blog makes at least one other interesting point claiming that at this pace we will have to wait until the 2020's before the unemployment rate hits 5% again:
"The economy lost almost 8.4 million jobs from December 2007 to December 2009. It added 1.1 million jobs in 2010. At December’s pace, just replacing the rest of those lost jobs would take 70 more months — roughly six years, taking us to November 2016...But the economy also needs to add 100,000 to 125,000 jobs a month just to keep pace with growth in the labor force... Even employment gains close to October’s pace (210,000 jobs) would take us into the next decade before seeing the unemployment rate back near 5%."
That's a bummer.  For considerably more analysis on the employment situation please read the Wall Street Journals Real Time Economics Blog. 

Wednesday, January 5, 2011

Initial Claims for Unemployment Insurance and the Business Cycle

The reliability of initial claims in predicting employment fluctuations depends on the state of the business cycle.  While generally very useful in forecasting employment during recessions, very early on in recovery however, they lose their predictive value.  This is because initial claims for unemployment are an important measure of layoffs, but changes in overall employment depend on both layoffs and hiring. 
Employment can fluctuate for one of three reasons: firms are hiring workers, firms are laying off workers, or workers decide to quit.  Claims provide us with a window into the layoff side of the labor market, but in order to paint the whole picture we need to also analyze the other main component- hiring- over the course of the business cycle.   
During recessions a strong inverse relationship exists as initial claims rise and hiring receeds.  During upturns, however, the systematic relationship between claims and hiring found during recessions virtually disappears, suggesting that layoffs are being driven by factors that differ from those driving hiring decisions.  Since hiring overshadows claims and claims move independently of hiring, claims alone cannot tell us much about the overall direction in employment. 
Thankfully, economic theory does not leave us hanging.  Because training new employees can be expensive, firms are often reluctant to fire workers as a way to cut costs and will tend to do so only when no other option is available.  During expansions, when hiring rates are high, firms are more likely to adjust to a slowdown in economic activity by hiring fewer workers than by laying off existing workers.  In contrast, during recessions, many firms seek to reduce the number of employees on their payrolls.  In implementing such cutbacks, these firms will be forced to hire fewer new workers and to lay off part of their existing workforce.

In light of this information we should be looking at hiring to determine where employment will be heading, not just initial claims.  So even though initial claims came in under 400,000 all that really means is that firms are laying off less workers versus hiring a ton of new workers.  Here is a graph of total private hires (right axis in thousands) vs. a 4-week moving average of initial claims (number on left hand side).  

Although hiring has yet to come up significantly it is important to note the data cuts off after october so it maybe misleading.  Nonetheless even with 'fresher' data we could still assume that we have a long way to go before our precious unemployment rate is brought down.  Another important indicator to look at when deciding whether the employment picture might turn is average weekly hours, but I'm feeling too lazy to put a graph of that up.        


All the data for my graph came from FRED (Duh!).

McConnell , Margaret M. “Rethinking the Value of Initial Claims as a Forecasting Tool”. From the Federal Reserve Bank of New York’s Current Issues In Economics and Finance; November 1998, Volume 4/Number 11. 

Tuesday, January 4, 2011

A graphical illustration of quantitative easing & the bond market rejection

On November 3, 2010 the F.O.M.C. announced that it would be purchasing 600 billion in treasuries on a schedule of $75 billion a month till the second quarter of 2011.  When the Fed does quantitative easing it is mostly just purchasing 2 to 10 year nominal U.S. treasury bonds.  The main channel through which quantitative easing is supposed to work is called the portfolio effect.  This works as follows, the Fed purchases treasuries therefore reducing the total supply on the open market.  The supply curve for treasuries in figure 1 shifts to the left from BS0 to BS1 as we move from A to B. Notice that their yield or the interest rate return falls from R0 to R1.  The fall in this interest rate causes investors to seek higher returns in assets with comparable maturities and interest rate risk structure.  A 10 year AAA corporate bonds yield would then be more attractive relative to 10 yr nominal treasuries and their demand curve in figure 2 would shift right from DCB0 to DCB1.  The lower interest rate on these corporate bonds would make it easier for firms with access to the capital markets to issue debt for long term business investment.

It is now January 4th, 2011 and we wish to see if the fed’s plan to spur long term investment is doing what the portfolio effect would suggest.  Figure A is the same as before with the fed reducing the total available supply of treasuries on the market. 

Figure B & C: The bond market rejects the purchases so the demand for treasuries shifts to the left from BD0 to BD1 and we move from point B to point C in figure B.  The Feds actions are completely negated in the treasury market.  Since AAA rated corporate bonds are closely tied to treasuries, the portfolio effect has also worked the other way.  This was witnessed when the demand for corporate bonds shifted to the left.  This is represented in figure C with the movement from A to B and a higher interest rate as the demand curve shifted from DCB0 to DCB1.  The higher interest rate discourages debt issuance for the support of long term investment.

As one can see from the following chart, this is exactly what occurred.  The bond market rejected the fed’s actions and started a massive sell off which lead to the steepening of the yield curve.
The following figure D, wraps up the story.  With the Fed agreeing to purchase 600 billion more treasuries, people may be feeling that bonds are overpriced and decided to take their money elsewhere, mainly the stock market.  The less risk adverse attitude and hope for a higher return led people to dump their bonds and buy other assets like equities.  The demand for equities in the diagram below shifts to the right from D0 to D1 as it moves from point A to B. 

The following chart describes that this is exactly what happened as the yield curve steepened so did the S&P rage.

Sunday, January 2, 2011

A Hybrid Policy: When A Price-Level Target Meets An Inflation Target

Happy New Year! This is a piece I wrote about a month or two ago for a Cleveland Fed position that I didn't get.  So enjoy!

In recent months, there has been much public interest in price-level targeting.  First as a standalone regime and second, as one that nicely compliments the more traditionally followed inflation targeting framework.  Much of the stir was generated following a speech advocating a hybrid policy given by the Federal Reserve Bank of Chicago President Charlie Evans to the Federal Reserve Bank of Boston’s 55th Economic Conference.  Although no central bank currently targets a price level, this idea is not new to the economic community.  The concept originally hails from Sweden’s Riksbank, which did it from 1931 to 1937 as a means of fending off both inflation and deflation after leaving the gold standard.  In addition, the economic environment in which Charlie Evans recommends the short-term adoption of a price-level target is not too dissimilar from the one Ben Bernanke made to the Japanese in the early 2000’s in dealing with the effects of many years of deflation on inflation expectations.  Both recommendations were given to economies characterized by liquidity traps and a falling rate of inflation and they also share the same goal, that is, to raise inflation expectations and lower real short-term interest rates at a time when nominal rates are at the lower bound.  Furthermore, the most recent recession that began in 2008 has been termed a “balance sheet recession” as many individuals and firms have been reluctant to increase their spending and investment until their own balance sheets look healthier.  Although a recent Economic Trends
highlights the significant progress that has already been made with respect to the deleveraging of mortgage debt, a hybrid policy that incorporates both inflation targeting and price-level targeting is seen as something that could aid in the healing process.

The Federal Reserve has a tool belt filled with a variety of instruments that all seek to achieve one goal, lower real interest rates to help support the recovery.  Quantitative easing has been seen as one way the Fed can lower real long-term interest rates by pushing down on the yield curve.  The Federal Open Market Committee (FOMC) recently announced at its November meeting that it would embark on a new round of Treasury purchases on the order of $600 billion.  By buying longer-term U.S. Treasuries, the Fed hopes to spur long-term investment while also helping to repair balance sheets by lowering the real interest rates at which firms access the capital markets.  This rather bold maneuver by the FOMC has been seen by many as an unconventional way to lower longer-term real interest rates.  One alternative to this program is for the Fed to declare a higher medium term inflation target, which works nicely through the Fisher equation:

Expected Inflation = Nominal Interest Rate - Real interest rate

This can be re-arranged as follows:

Real Interest rate = Nominal Interest rate – Expected inflation

This relationship can be used to explain the logic behind raising the inflation target, as higher expected inflation would result in lower real interest rates, therefore spurring investment through the lower cost of borrowing.  Furthermore, the lower real interest rate decreases the debt burden in real terms, thus reducing the financial strain felt by leveraged households and firms.  The problem is that many central bankers, including Ben Bernanke, are vehemently opposed to such a policy as it is thought to undermine and threaten the inflation fighting credibility the Fed has fought hard for.

Chairman Bernankes’ speech on Monetary policy at Jackson Hole, Wyoming clearly shows his opposition to a higher medium-term inflation target:

“…raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy.”

Price-level targeting is seen as a way to avoid unleashing inflation expectations
while also preventing a deflationary scenario.  It is important to note that much of the research advocates using price-level targeting to avoid a deflationary spiral during a liquidity trap.  Charlie Evans October 16th speech in Boston that re-kindled this debate and also advocates this policy.  This is because at the zero bound, where nominal interest rates are near zero, a deflationary shock lowers the expected inflation rate which then increases the real interest rate.  When we are at the zero bound, the only way to decrease the real rate is to increase inflationary expectations.  While quantitative easing is seen as operating through the Fisher mechanism by lowering nominal long-term rates, it has been argued that each additional round of bond purchases will have a diminishing effect on yields.  A hybrid policy involving elements of both price-level targeting and inflation targeting has been seen by many as an appropriate alternative to raising the medium term inflation target and further quantitative easing.  

Defining price-level targeting:

With a price-level target, a central bank commits to following a given path for the absolute level of prices over some specified horizon.  Practically, all this requires is following the index level of the core personal consumption expenditures price index (Core PCE) from some initial time period.  If prices start rising faster than the targeted path, monetary policy makers will be forced to lower inflation in the future to get the price level back on the target path.   Conversely, if there is a deflationary shock, the central bank must inflate in the future in order to bring the price level back up. 

Exhibit A. Price-level targeting:  Suppose the desired inflation rate is 2 percent so the price-level target is rising at 2 percent every year has also been rising 2 percent every year from year 1 to year 3.  Then the inflation rate jumps to 4 percent in year 4.  With the price-level target the overshoot in inflation requires the central bank to move the price level back to the target path, which means that for a time the central bank will shoot for an inflation rate below 2 percent.
Exhibit B. Inflation-level targeting: Suppose the inflation target is 2 percent so the price-level is rising at 2 percent every year and inflation has also been rising at 2 percent every year from year 1 to year 3.  Then the inflation rate jumps to 4 percent in year 4.  With an inflation target, the price-level path that is targeted is raised to accommodate the increased price level (let bygones be bygones), so the central bank still tries to achieve an inflation rate of 2 percent.

What is inflation targeting exactly and why is it different from price-level targeting?

Inflation targeting is when a central bank chooses to hold inflation constant and aims for either a set point or a range.  A credible inflation target is said to anchor inflation expectations therefore acting as a preventative measure against inflationary or deflationary shocks.  The difference between the price level targeting and inflation targeting framework lies in the way realized inflation is handled. 

In short, Charles T. Carlstrom and Andrea Pescatori of the Federal Reserve Bank of Cleveland put it best:

“An inflation target “lets bygones be bygones,” while a price-level target corrects for past misses. If prices fall on a year-over-year basis, a price-level target requires the central bank to reinflate prices until they are back to the target. An inflation target requires only that the rate of inflation be returned to its target rate from the present onward.”

The relative disadvantage of targeting the inflation rate is that unanticipated shocks to the price level may be treated as bygones and never offset (Exhibit B).  This results in forecasts of the price level at long horizons that might have a large variance under inflation targeting, which presumably impede private sector planning.  Going the other way, strict price-level targeting requires that overshoots or undershoots of the target be fully made up, which reduces the variance of long-run forecasts of prices but could impart significantly more volatility in the short run (Exhibit A). 

In 2002, an Economic Commentary by Charles T. Carlstrom and Timothy S. Fuerst made the argument that inflation targeting fails because it has to be forward looking.  This is because the effects of monetary policy are only realized after relatively long lags, so preemptive strikes are necessary and these require basing policy off of inflation expectations.  To prevent prices from rising in the short term monetary policy makers must react to changes in expected inflation, but this action may lead to self-fulfilling cycles of expected inflation, which would then have the ability to actually increase inflation variability.  To avoid this self-fulfilling cycle and all of its issues the authors suggest price-level targeting because it is easily verifiable and naturally builds in a backward looking element.  Additionally, the authors argue that although the two frameworks are sometimes used interchangeably, there is one crucial difference between an inflation target and a price-level target: 

“With an inflation target, past inflation misses do not affect future policy actions. That is, there is base drift. With a price-level target, however, past misses must affect future policy actions because the monetary authority has to get the price level back on track. To bring prices back down, the central bank must respond to increases in yesterday’s inflation by increasing the funds rate today.”

Another way to think about price-level targeting in practice is that a deflationary shock today will lead to higher compensatory inflation in the future, which results in higher inflation expectations.  The promise of future inflation (which is the immediate result of the deflationary shock) raises inflationary expectations which then effectively lowers the real rate. 

Frederic S. Mishkin’s Monetary Policy Strategy is particularly useful for this debate.  It weighs in on both the advantages and disadvantages of price-level targeting relative to inflation targeting.  With the respect to the advantages, a price-level target can reduce the uncertainty about what the price level will be over long horizons.  As discussed earlier, with an inflation target, misses of the inflation target are not reversed by the central bank.  This results in inflation being a stationary stochastic process while the price-level will be nonstationary.  This implies that the uncertainty regarding the future price level actually grows with the forecast horizon.  Although the amount of long-run uncertainty regarding the future price level, which stemmed from adherence to an inflation target may not be all that large, nevertheless it still complicates the planning process and may lead to more mistakes in investment decisions.  This uncertainty can make long-run planning more challenging and may therefore lead to decreased economic efficiency. 
David Atlig, the main contributor to the Atlanta Fed’s Macroblog, also weighs in on the debate arguing that some potential benefits to a strictly price-level targeting regime include that it:

“(a) is clearly consistent with longstanding Federal Open Market Committee (FOMC) behavior; (b) avoids a potentially confusing impression that the central bank is jumping from one framework to another to serve whatever is convenient at the moment; and (c) gives the public a clearer way to monitor if and when the long-term price-level objective is being compromised.”

There are however also disadvantages that follow with a price-level target.  The traditional view argues that in non forward looking models a price-level target could produce more output variability because overshoots or undershoots of the target must be reversed.  This undoubtedly could cause significantly more volatility to monetary policy, especially with sticky prices, to the real economy in the short run. 
A second problem is that a price-level target may lead to more frequent episodes of deflation because an overshoot of the target would require inflation to be lower than usual for sometime.  If the price-level target did lead to episodes of deflation, then the problems of financial instability and having the interest rate hit the zero lower bound could be harmful to the economy.  This is because an overshoot of the target would force the central bank to create a deflationary scenario that could, in theory, cause a debt deflation.  This would obviously be a problem if the amount of leverage within the economy is exceptionally high.
Given the recent financial crises, one could see the possible argument against price-level targeting especially if the original inflationary episode was a result of a one time negative supply shock.  The boost to inflation would be temporary, but the change to the price level permanent.  The Fed would be required to counteract the negative supply shock or make an exception to the rule.  The downside of making exceptions is that overtime the lack of consistency could seriously impact the Fed’s credibility.  On the other hand choosing to counteract every onetime change in inflation could lead to financial instability.  For example, if the Fed was obligated to counteract every one time inflationary shock without regard to the broader conditions of the overall economy , especially with respect to debt, it could trigger a financial crises as an increase in real interest rates increases the real debt burden and leads to default.  Conversely, positive shocks such as lower oil prices or higher productivity would require the Fed to raise future inflation and the increase in inflation expectations drives down real interest rates thus putting the Fed at risk of creating asset inflation.
A third issue with price-level targeting is raised with respect to the difficulty in communication.  Although It has already been mentioned, that the fed would have an issue with explaining its actions in response to one time price shocks, there may also be an informational barrier that complicates communicating what exactly a price-level targeting central bank looks at.  A price-level target may be more challenging to explain than an inflation target because the fact the optimal inflation rate is almost surely positive requires that the price-level target rise over time.  Thus, the Fed would have to explain that the price-level target is a moving target, which is more complicated than explaining that the central bank has a constant inflation rate. 

Would price-level targeting actually work?

The success of a price-level target will depend heavily upon how people form their expectations of future inflation.  If people remain relatively current and understand the Fed’s price-level targeting policy, then it will be undisputed as they will raise their inflation expectations in line with the Fed’s moving target.  If people are more backwards looking, meaning their future inflation expectations rely heavily on past inflation, then price-level targeting will lose its potency as changing inflation expectations will require changing inflation itself. 

Can we meet somewhere in the middle? Meshing together inflation and price-level targeting. 

A hybrid policy that combines features of both an inflation target and price-level target might provide us with the best of both worlds.  Operationally, an inflation target could be announced with a commitment to some error correction in which target misses would be offset to some extent in the future.  An inflation target with some error correction can reduce the uncertainty about the price level in the long run, while also decreasing the likelihood of deflation.  However, one problem with this hybrid policy is explaining it to the general public.  Much of the success attributed to inflation targeting stems from the clear communications strategy so anything that relies on the term “error correction” may make that more difficult. 
A more reasonable hybrid policy would be to pursue an inflation target under normal conditions, but to provide an escape clause that initiates a price-level target only if the rare condition of deflation sets it, particularly if short-term nominal interest rates are at the zero bound.  This way the inflation target under normal conditions would not require that overshoots of the inflation target be reversed and so would not increase the probability of deflation.  Furthermore, if deflation set in, then activating a price-level target to induce expectations of future inflation would not only make it less likely that nominal interest rates hit or remain at zero, but would lead to higher inflation expectations.  As we have seen, this works through the Fisher effect to lower real interest rates, which help stimulate the economy.  This leads to a rise in the price level and helps to repair ailing balance sheets because inflation reduces the real debt burden.  With lower debt on the balance sheet, firms and households, uncertainty aside, may be inclined to spend some of that extra cash.   

Atlig, David. "A good time for price level targeting?" Macroblog. Federal Reserve Bank of Atlanta, 20 Oct 2010. Web.
Bernanke, Ben S. "The Economic Outlook and Monetary Policy." Economic Symposium. Federal Reserve Bank of Kansas City. Jackson Hole , Wyoming. 27 Aug 2010. Speech.
Bernanke, Ben S. and Frederic S. Mishkin “Inflation Targeting: A New Framework for Monetary Policy?”  From Monetary Policy Strategy. Cambridge, MA: The MIT Press, 2007. 207-23. Print
Carlstrom, Charles T, and Andrea Pescatori. "Conducting Monetary Policy when Interest Rates Are Near Zero." Economic Commentary 21 Dec 2009: Federal Reserve Bank of Cleveland. .
Carlstrom, Charles T, and Timothy S. Fuerst. " Monetary Policy Rules and Stability: Inflation Targeting versus Price-Level Targeting” Economic Commentary 15 Feb 2002: Federal Reserve Bank of Cleveland. 
Demyanyk, Yuliya and Matthew Koepke. “Mortgage Borrowers Deleverage” Economic Trends 22 Nov 2010: Federal Reserve Bank of Cleveland.
Evans, Charlie. "Monetary Policy in a Low-Inflation Environment: Developing a State-Contingent Price-Level Target." Federal Reserve Bank of Boston’s 55th Economic Conference. Boston, MA. 16.10.2010. Speech. <>
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