In a nice post on the New York Fed’s blog, Liberty Street Economics, Marc Giannoni and Hannah Herman write on price level targeting. In a nutshell, they observe that, whatever the FRB said it was doing ex ante, ex post it has brought about a trend-stationary price level, which is what you would get if you were ‘price level targeting’. The question is begged: so why not consolidate this into a formal Price Level Target to lock in the benefits?
A few comments.
1. First, suppose, as most of the analytical work assumes, that expectations are rational. In this case it seems unlikely that a price level target would be credible. Imagine a few boom years where inflation has got away from the central bank a little and the price level has risen above target. Is the central bank really going to be believed that it will deliberately engineer a recession to make up for it? I doubt it. In which case expectations won’t respond as the NYFed bloggers describe, and an even more draconian tightening would be required to bring about the price level correction. In the case of the US, maybe one could argue that since the price level has been trend-stationary over the recent past, people will continue to think that it will be over the future, so a PLT will be credible. But on the other hand, you could argue that people might think ‘The Fed have all this time been pursuing a secret PLT, deceiving us. So they say they are doing PLT now, but perhaps they have just switched to a new secret target.’
2. Second, perhaps expectations are not rational after all!! [I can hear the sniggers of non-practicioners in macro] In which case the benefits from having a lever over forward expectations don’t materialise. This was one of the reasons that the Bank of Canada concluded that it would be unwise to do PLT in its public research review of the topic.
3. There is a third reason why I don’t like PLT, and it will sound a bit unscientific. [That is, more so than other macro-style arguments which as a newcomer to the blog and twittersphere I realise are rejected as unscientific anyway]. The benefits of price level certainty are clear in RE models with the very arbitrary way we have of modelling sticky prices and the value people place on (surely actually worthless) paper money. The fine details of optimal monetary policy depend quite a bit on these arbitrary choices. Both are completely question-begging. Why the hell are prices sticky if it’s so costly? Where do the costs come from. The QJE and AER are stuffed full of hard papers on this. And why do people hold money and how will the value they place on it fluctuate? Likewise, the top journals have been peppered with great work on this [including Steve Williamson, author of the blog ‘new monetarist economics’]. It seems extremely odd to me to fine tune the monetary regime in favour of conclusions reached in a particular New Keynesian model of sticky prices and money, when these two crucial features of the model are so question-begging.
4. To believe that the Fed should switch to PLT seems to me to be unwise. [To be fair Giannoni and Herman don’t actually recommend this, but they might be interpreted as doing that]. It requires us thinking: the Fed should not actually do anything different at all, because it has been doing what it needs to do to generate a trend-stationary price level; everyone saw and understood exactly what the Fed was doing, since they have rational expectations, and they perceived the Fed to be committed to carrying on doing it; following the change in communication, nothing else will happen. There will be no misunderstanding or incomplete credibility surrounding the new policy. In a sense, a formal switch would be a contradiction. No need to do anything different, and, since expectations are rational, no need to say anything different [or anything at all]. Working backwards, since central banks think communication is very important, and take great care over it [witness the tip-toeing about quantifying the inflation target over many years, or broaching the idea of ‘tapering’ asset purchases], one might infer that expectations are quite different from those that guarantee the benefits of PLT, in which case, better leave well alone.
5. Ultra-nerdy point and a bit of blatant self-publicity. In this piece of work coauthored with Andy Blake and Tatiana Kirsanova, we explain how much of the past work studying the benefits of price level targeting neglect the fact that you can have multiple rational expectations outcomes. Without a closer look, you can’t tell whether moving from an inflation target to a price level target is going to improve things or not. In fact PLT doesn’t come out too badly.