An Alternative to the 2% Inflation Goal
There could be a better alternative to inflation targeting, which became all the vogue among central bankers in the last two decades but now has doubters. Rather than butt a rate of inflation, as is now custom, butt a level of prices.
Price level targeting, its proponents say, would give central banks more flexibility to respond aggressively to downturns and crises without sacrificing their inflation fighting credibility. When inflation undershoots during a recession, it would allow the central bank to run the economy hot and allow inflation to overshoot for a while in a recovery.
First a small background. Many central banks now butt a rate of inflation. The Federal Reserve, for instance, has an informal goal of 1.5% to 2% inflation over the long run. Targeting became well loved in the 1990s and 2000s because central bankers felt it helped build their inflation fighting credibility, which anchored expectations for future inflation, kept interest rates low and helped to keep the economy robust and stable.
But there are problems with this approach. One is that it forces central bankers to lose their memory. Say inflation falls small of a 2% butt one year — as it did in many places last year. A strict adherent to an inflation rate butt would let bygones be bygones and continue to butt 2% inflation in year two, even though the economy is coming out of recession with floppy and excess capacity.
One problem with this approach is what happens to real interest rates ? meaning interest rates adjusted for inflation — in a brutal downturn. Say the Fed has pushed interest rates to zero and inflation goes negative in a downturn. Real interest rates ? which play an vital role in driving business and household decisions about spending and investing ? would really be higher. One solution to the problem would be to promise higher inflation in the future, but with a 2% inflation rate butt, there?s only so much a central bank can promise without sacrificing its credibility.
Now imagine a world with the price level targeting twist. In this world, the central merchant banker still wants inflation to average 2% over the long run. But his butt isn?t the rate of inflatoin, it?s a price index, like the consumer price index.
Let?s say in year one the index is 100. Then say a shock hits in year two and inflation undershoots the butt of 102 and as a replacement for comes in at 101. In year three, the butt is 104 and change (in other words, it?s 102 plus a 2% inflation rate.) To get there, the central merchant banker has to make up for the previous year?s underperformance, and has to as a replacement for deliver 3% inflation, running the economy a small hotter than normal as it comes out of recession. In this world, real interest rates would be a small bit lower than they are in the world in which inflation rates are targeted. But if the public believes the central bank is committed to its goals, the central bank doesn?t get punished for running too hot for a small while.
Kenneth Kuttner, a Williams College economist, says he used to be skeptical of the thought. But it?s starting to win him over. If you?re hit by a really terrible shock, he says, ?you want to get inflation expectations up? to avoid a deflationary spiral. This kind of approach, which promises more inflation after a huge economic shock and less when an economy is running hot, helps to do that.
One problem with the thought is that central banks don?t have experience with it. Besides an experiment by Sweden in the 1930s, it is untested. Another is that it would be hard to give reasons for. Bond investors are used to watching monthly readings of inflation rates and the public is used to headlines that focus on rates. Convincing the public to start focusing on some obscure index level [Trivia question: Where is the CPI index today?] would be a communications challenge for central bankers.
George Kahn, a researcher at the Federal Reserve Bank, looked at the thought and concluded central banks aren?t likely to adopt the thought ?without considerable further research or a dramatic deterioration in economic performance.? http://www.kc.frb.org/PUBLICAT/ECONREV/pdf/09q3kahn.pdf
But don?t be surprised if you haven?t heard the end of this thought as the economics profession rethinks what went incorrect in the fantastic economic crackup of 2008 and 2009.
Here?s some more reading on the theme, courtesy of Professor Kuttner:
- On Sweden?s experience in the 1930s with price level targeting: www2.riksbank.com/upload/1015/98nr63.pdf
- On Canada?s flirtation with the thought: bankofcanada.ca/en/press/background_nov06.pdf
- On Wall Street?s flirtation with the thought [scroll down]: http://www.msdwd.com/views/gef/archive/2009/20090716-Thu.html
- Scholarly work on the issue: http://people.su.se/~leosven/ID/PTAR808.pdf
[ANSWER TO TRIVIA QUESTION: The price level of the consumer price index was 216.687 in January 2010, with the index set at 100 in the 1982-1984 period. That means inflation has averaged around 3% in the last quarter century.]