Kocherlakota's Case for Price Level Targeting

Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, described the benefits of price level targeting to the Economic Club of Minnesota on May 21. He began by explaining that Congress has charged the FOMC with making monetary policy to promote price stability and maximum employment. Since January 2012, the FOMC has interpreted an inflation rate of 2% as most consistent with the price stability part of the mandate.

Since the adoption of the 2% inflation target, inflation, as measured by the annual change in the price index for personal consumption expenditures, has actually been just above 1%. Kocherlakota agrees with the Congressional Budget Office forecast that inflation will not reach 2% until around 2018. He explains why below-target inflation is a problem:

"The low inflation in the United States tells us that resources are being wasted. What exactly are these wasted resources? ...the biggest and most disturbing answer is our fellow Americans. There are many productive people in the United States available to work more hours, and our society is deprived of their production. 

This key point is generally underappreciated. I’ve said that the FOMC is undershooting its price stability objective and is expected to continue to do so. But we should all keep in mind that this outcome—and especially the forecast for continued undershooting—typically means that the FOMC is also underperforming on its other objective of promoting maximum employment."

Kocherlakota notes that "the downside misses with respect to inflation cumulate into a significantly lower price level. If my inflation forecast is right, the price level in 2018 will be about 2.5 percent below what it would have been had the FOMC hit its inflation target over the preceding six years." Then he asks, "How should the FOMC’s inflation goals in the years following 2018 be influenced by the undershooting of the inflation target in the preceding years?"

He describes two main benefits of adopting price level targeting, instead of inflation targeting. (His disclaimer: "I won’t take a stand today on which of those approaches is better. My goal is simply to initiate a policy conversation about future—indeed, possibly far-off future—monetary policy choices.") With price level targeting, the central bank targets a set path for the price level, rather than a set rate of change in the price level. If an inflation-targeting central bank undershoots its 2% target one year, it will still target 2% the next year. A price level-targeting central bank could target a path for the price level with a 2% growth rate, but if inflation is less than 2% one year, it will need to be above 2% the next year to get the price level back up to the targeted path. Here are Kocherlakota's two reasons why price level targeting could be a better option:

"The first reason is that price level targeting makes long-term contracts safer for borrowers and lenders. For example, suppose a family took out a 30-year mortgage in 2012, under the expectation that the FOMC would deliver on its commitment to keep inflation at 2 percent. Because inflation has been so low over the past two years, the borrower’s current repayments are now surprisingly expensive in real terms...The FOMC can’t solve that problem today, But if the FOMC uses inflation targeting, the borrower’s repayments are likely to remain surprisingly expensive in real terms even in 2042...In contrast, if the FOMC uses price level targeting, the borrower’s repayments in 2042 are likely to be close, in real terms, to what the borrower expected when originally taking on the loan. 

The second reason that the FOMC might want to use price level targeting is that it would serve as an automatic stabilizer for the economy. As I described earlier, when demand is low, inflation tends to be below target. With price level targeting, the FOMC makes up for low inflation by using monetary policy to stimulate higher future inflation and higher future demand. But this prospect of higher future demand is an incentive for businesses to hire and invest more now. Thus, with price level targeting, the FOMC’s anticipated future policy choices automatically offset current adverse shocks."

I don't think a switch to price level targeting is likely in the near term. It would (nearly) be a global first. Only the Swedish Riksbank, from 1931-37, has explicitly targeted the price level. The Bank of Canada, an inflation-targeting regime since 1991, seriously considered switching to price level targeting, but decided against it in 2011.

Meanwhile, other Fed officials and researchers claim that in practice, the FOMC has behaved as if it were price level targeting. St. Louis Fed President James Bullard notes that if we take the 1995 price level and project a 2 percent inflation price level path from that point forward, the actual U.S. price level close to this path. Similarly, Dave Altig and Mike Bryan at the Atlanta Fed calculate that "If you accept that the Fed, for all practical purposes, adopted a 2 percent inflation objective sometime in the early to mid-1990s, there arguably really isn't much material distinction between its inflation-targeting practices and what would have likely happened under a regime that targeted price-level growth at 2 percent per annum. The actual price level today differs by only about 0.5 to 1.5 percentage points from what would be implied by such a price-level target." They explain:

"In principle, there is no reason why a central bank consistently pursuing an inflation target can't deliver the same outcomes as one that specifically and explicitly operates with a price-level target. Misses with respect to targeted inflation need not be biased in one direction or another if the central bank is truly delivering on an average inflation rate consistent with its stated objective."

In other words, they are saying that since inflation targeting allows base drift and price level targeting does not, but as long as base drift averages out to zero, there is not much difference. Since the early to mid-90s, the FOMC has approximately balanced out its overshooting and its undershooting of 2% inflation. This is an average over several business cycles, though, so the automatic stabilizer benefits that Kocherlakota mentions would not have been reaped. This also includes the years before the Fed adopted its explicit 2% inflation target. It seems like there was greater willingness to let inflation go above 2% when the target was not explicit. Mark Thoma has noted that comments made by some Fed officials could indicate that the Fed viewed the costs of overshooting and undershooting its target as asymmetric--that the target is actually more of a ceiling. If this is the case, than misses with respect to targeted inflation will likely be biased downward. A shift to treating the target as a true target, with symmetric costs of overshooting and undershooting, and sufficient weight on the employment part of the mandate, may be an easier-to-implement solution than an explicit price-level target.