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. <>
"Level worship: Price-level targeting could make monetary policy more potent—or just more confusing." Economist 28 Oct 2010:Web. .
McCallum, B. T. 1999. “Issues in the Design of Monetary Policy Rules.” In Handbook of Macroeconomics, edited by J. B. Taylor and M. Woodford. Amsterdam: North-Holland.
Mishkin, Frederic S. and Klaus Schmidt-Hebbel “A Decade of Inflation Targeting in the World: What Do We Know and What Do We Need to Know?” From Monetary Policy Strategy, Cambridge, MA: The MIT Press, 2007. 405-40. Print
Sack, Brian and Joseph Gagnon, Matthew Raskin, Julie Remache, "Large-Scale Asset Purchases by the Federal Reserve: Did They Work?" Federal Reserve Bank of New York Staff Report no. 441, March 2010

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