Thoughts on the Fed's New Labor Market Conditions Index

I'm usually one to get excited about new data series and economic indicators. I am really excited, for example, about the Fed's new Survey of Consumer Expectations, and have already incorporated it into my own research. However, reading about the Fed's new Labor Market Conditions Index (LMCI), which made its debut in the July 15 Monetary Policy Report, I was slightly underwhelmed, and I'll try to explain why.

David Wessel introduces the index as follows:

Once upon a time, when the Federal Reserve talked about the labor market, it was almost always talking about the unemployment rate or the change in the number of jobs. But the world has grown more complicated, and Fed Chairwoman Janet Yellen has pointed to a host of other labor-market measures. 

But these different indicators often point in different directions, which can make it hard to tell if the labor market is getting better or getting worse. So four Fed staff economists have come to the rescue with a new “labor markets conditions index” that uses a statistical model to summarize monthly changes in 19 labor-market into a single handy gauge.

The Fed economists employ a widely-used statistical model called a dynamic factor model. As they describe:

A factor model is a statistical tool intended to extract a small number of unobserved factors that summarize the comovement among a larger set of correlated time series. In our model, these factors are assumed to summarize overall labor market conditions. What we call the LMCI is the primary source of common variation among 19 labor market indicators. One essential feature of our factor model is that its inference about labor market conditions places greater weight on indicators whose movements are highly correlated with each other. And, when indicators provide disparate signals, the model's assessment of overall labor market conditions reflects primarily those indicators that are in broad agreement.

The 19 labor market indicators that are summarized by the LMCI include measures of unemployment, underemployment, employment, weekly work hours, wages, vacancies, hiring, layoffs, quits, and sentiment in consumer and business surveys. The data is monthly and seasonally adjusted, and the index begins in 1976.

A minor quibble with the index is its inclusion of wages in the list of indicators. This introduces endogeneity that makes it unsuitable for use in Phillips Curve-type estimations of the relationship between labor market conditions and wages or inflation. In other words, we can't attempt to estimate how wages depend on labor market tightness if our measure of labor market tightness already depends on wages by construction.

The main reason I'm not too excited about the LMCI is that its correlation coefficient with the unemployment rate is -0.96. They are almost perfectly negatively correlated--and when you consider measurement error you can't even reject that they are perfectly negatively correlated-- so the LMCI doesn't tell you anything that the unemployment rate wouldn't already tell you. Given the choice, I'd rather just use the unemployment rate since it is simpler, intuitive, and already widely-used.

In the Monetary Policy Report, it is hard to see the value added by the LMCI. The report shows a graph of the three-month moving average of the change in LMCI since 2002 (below). Values above zero are interpreted as an improving labor market and below zero a deteriorating labor market. Below the graph, I placed a graph of the change in the unemployment rate since 2002. They are qualitatively the same. When unemployment is rising, the index indicates that labor market conditions are deteriorating, and when unemployment is falling, the index indicates that labor market conditions are improving.

The index takes 19 indicators that tell us different things about the labor market and distills the information down to one indicator based on common movements in the indicators. What they have in common happens to be summarized by the unemployment rate. That is perfectly fine. If we need a single summary statistic of the labor market, we can use the unemployment rate or the LMCI.

The thing is that we don't really need or even want a single summary statistic of the labor market to be used for policymaking. The Fed does not practice rule-based monetary policy that requires it to make policy decisions based on a small number of measures. A benefit of discretionary policy is that policymakers can look at what many different indicators are telling them. As Wessel wrote, "the world has grown more complicated, and Fed Chairwoman Janet Yellen has pointed to a host of other labor-market measures." Yellen noted, for example, that the median duration of unemployment and proportion of workers employed part time because they are unable to find full-time work remain above their long-run average. This tells us something different than what the unemployment rate tells us, but that's OK; the FOMC has the discretion to take multiple considerations into account.

The construction of the LMCI is a nice statistical exercise, and the fact that it is so highly correlated with the unemployment rate is an interesting result that would be worth investigating further; maybe this will be discussed in the forthcoming FEDS working paper that will describe the LMCI in more detail. I just want to stress the Fed economists' wise point that "A single model is...no substitute for judicious consideration of the various indicators," and recommend that policymakers and journalists not neglect the valuable information contained in various labor market indicators now that we have a "single handy gauge."

Economic Inclusion and the Global Common Good

On July 11 and 12, Pope Francis met with a group of policymakers, economists, and other influential thinkers at a conference called “The Global Common Good: Towards a More Inclusive Economy.” The conference was sponsored by the Pontifical Council for Justice and Peace and held at the Pontifical Academy of Science in Vatican City.

Pope Francis spoke out against "anthropological reductionism" in the economy, echoing a tradition of Catholic social teaching that links economic inclusion to human dignity. The 1986 pastoral letter Economic Justice for All says:

"Every economic decision and institution must be judged in light of whether it protects or undermines the dignity of the human person...We judge any economic system by what it does for and to people and by how it permits all to participate in it. The economy should serve people, not the other way around... 

All people have a right to participate in the economic life of society. Basic justice demands that people be assured a minimum level of participation in the economy. It is wrong for a person or group to be excluded unfairly or to be unable to participate or contribute to the economy. For example, people who are both able and willing, but cannot get a job are deprived of the participation that is so vital to human development. For, it is through employment that most individuals and families meet their material needs, exercise their talents, and have an opportunity to contribute to the larger community. Such participation has special significance in our tradition because we believe that it is a means by which we join in carrying forward God's creative activity."

One participant at the conference was Muhammad Yunus, a pioneer of microcredit and microfinance and the founder of Grameen Bank in Bangladesh. Grameen Bank is called the bank of the poor because its borrowers, mostly poor and female, own 95% of the bank's equity. Yunus and the Grameen Bank jointly won the Nobel Peace Prize in 2006. Yunus has a PhD in economics from Vanderbilt and is the author of Banker to the Poor and Creating a World Without Poverty. At the conference, Yunus spoke about social business and about sharing and caring as basic human qualities.

Development economist Jeffrey Sachs also attended the conference. Sachs, author of The End of Poverty, founded the ambitious and controversial Millennium Villages Project. For a glimpse into the project from two different perspectives, I recommend Russ Roberts' interviews with Sachs and Nina Munk on the EconTalk podcast. 

Mark Carney, Governor of the Bank of England, attended the conference as well. Carney has spoken previously about economic inclusion. He gave a speech at the Conference on Inclusive Capitalism in London this May, in which he remarked:

"To maintain the balance of an inclusive social contract, it is necessary to recognise the importance of values and beliefs in economic life. Economic and political philosophers from Adam Smith (1759) to Hayek (1960) have long recognised that beliefs are part of inherited social capital, which provides the social framework for the free market. Social capital refers to the links, shared values and beliefs in a society which encourage individuals not only to take responsibility for themselves and their families but also to trust each other and work collaboratively to support each other.

So what values and beliefs are the foundations of inclusive capitalism? Clearly to succeed in the global economy, dynamism is essential. To align incentives across generations, a long-term perspective is required. For markets to sustain their legitimacy, they need to be not only effective but also fair. Nowhere is that need more acute than in financial markets; finance has to be trusted. And to value others demands engaged citizens who recognise their obligations to each other. In short, there needs to be a sense of society."

Also in attendance were Jose Angel Gurria, Secretary General of the OECD; Michel Camdessus, former managing director of International Monetary Fund; Ngozi Okonjo-Iweala, Finance Minister of Nigeria; Donald Kaberuka, President of the African Development Bank; and Huguette Labelle of Transparency International. A complete list of attendants and more detailed remarks from the conference should be up at the Pontifical Council for Justice and Peace website in the next few days.  I look forward to seeing what kinds of practical proposals might have been discussed.

The Unemployment Cost of Below-Target Inflation

Recently, inflation in the United States has been consistently below its 2% target. The situation in Sweden is similar, but has lasted much longer. The Swedish Riksbank announced a 2% CPI inflation target in 1993, to apply beginning in 1995. By 1997, the target was credible in the sense that inflation expectations were consistently in line with the target. From 1997 to 2011, however, CPI inflation only averaged 1.4%. In a forthcoming paper in the AEJ: Macroeconomics, Lars Svensson uses the Swedish case to estimate the possible unemployment cost of inflation below a credible target.

Svensson notes that inflation expectations that are statistically and economically higher than inflation for many years do not pass standard tests of rationality. He builds upon the "near-rational" expectations framework of Akerlof, Dickens, and Perry (2000). In Akerlof et al.'s model, when inflation is fairly close to zero, a fraction of people simply neglect inflation, and behave as if inflation were zero. This is not too unreasonable--it saves them the computational trouble of thinking about inflation and isn't too costly if inflation is really low. Thus, at low rates of inflation, prices and wages are consistently lower relative to nominal aggregate demand than they would be at zero inflation, permitting sustained higher output and employment. At higher levels of inflation, fewer people neglect it. This gives the Phillips Curve has a "hump shape"; unemployment is non-monotonic in inflation but is minimized at some low level of inflation.

In the case of Sweden, the near-rational model is modified because people are not behaving as if inflation were zero, but rather as if it were 2%, when in fact it is lower than 2%. Instead of permitting higher output and employment, the reverse happens. The figure below shows Svensson's interpretation of the Swedish economy's location on its hypothetical modified long-run Phillips curve. The encircled section is where Sweden has been for over a decade, with inflation mostly below 2% and unemployment high. If inflation were to increase above 2%, unemployment would actually decline, because people would still behave as if it were 2%. But there is a limit. If inflation gets too high (beyond about 4% in the figure), people no longer behave as if inflation were 2%, and the inflation-unemployment tradeoff changes sign.

Source: Svensson 2014

As Svensson explains,

"Suppose that nominal wages are set in negotiations a year in advance to achieve a particular target real wage next year at the price level expected for that year. If the inflation expectations equal the inflation target, the price level expected for next year is the current price level increased by the inflation target. This together with the target real wage then determines the level of nominal wages set for next year. If actual inflation over the coming year then falls short of the inflation target, the price level next year will be lower than anticipated, and the real wage will be higher than the target real wage. This will lead to lower employment and higher unemployment."

Svensson presents narrative evidence that central wage negotiations in Sweden are indeed influenced by the 2% inflation target rather than by actual inflation. The wage-settlement policy platform of the Industrial Trade Unions states that "[The Riksbank’s inflation target] is an important starting point for the labor-market parties when they negotiate about new wages... In negotiations about new wage settlements, the parties should act as if the Riksbank will attain its inflation target."

The figure below shows the empirical inflation-unemployment relationship in Sweden from 1976 to 2012. The long-run Phillips curve was approximately vertical in the 1970s and 80s. The observations on the far right are the economic crisis of the early 1990s. The points in red are the inflation targeting regime. The downward-sloping black line is the estimated long-run Phillips curve for this regime with average inflation below the credible target. You can see two black dots on the line, at 2% inflation and at 1.4% inflation (the average over the period). The distance between the dots on the unemployment axis is the "excess unemployment" that has resulted from maintaining inflation below target. The unemployment rate would be about 0.8% lower if inflation averaged 2% (and presumable lower still if inflation averaged slightly above 2%).

Source: Svensson 2014

Can this analysis be applied the the United States? Even though the U.S. has only had an official 2% target since January 2012, Fuhrer (2011) notes that inflation expectations have been stabilized around 2% since 2000, since the Fed was presumed to have an implicit 2% target. The figure below plots unemployment and core CPI inflation in the U.S. from 1970 to 2012, with 2000 and later in red. Like in Sweden, the long-run Phillips curve is downward-sloping in the (implicit) inflation-targeting period. Since 2000, however, average U.S. inflation was 2%, so overall there was no unemployment cost of sustained below-target inflation. The downward slope, though, means that if we get into a situation like Sweden's where we consistently undershoot 2%, which could result if the target is treated more like a ceiling than a symmetric target, this would have excess unemployment costs.

Source: Svensson 2014

Svensson concludes with policy implications:

"I believe the main policy conclusion to be that if one wants to avoid the average unemployment cost, it is important to keep average inflation over a longer period in line with the target, a kind of average inflation targeting (Nessén and Vestin 2005). This could also be seen as an additional argument in favor of price-level targeting...On the other hand, in Australia, Canada, and the U.K., and more recently in the euro area and the U.S., the central banks have managed to keep average inflation on or close to the target (the implicit target when it is not explicit) without an explicit price-level targeting framework.  

Should the central bank try to exploit the downward-sloping long-run Phillips curve and secretly, by being more expansionary, try to keep average inflation somewhat above the target, so as to induce lower average unemployment than for average inflation on target?...This would be inconsistent with an open and transparent monetary policy."

Recommended Reading from the Fed

There are two particularly good reads posted by Federal Reserve economists today. The first is "Deleveraging: Is it over and what was it?" by Claudia Sahm. The role of household deleveraging in the Great Recession has been heavily emphasized, notably at Atif Mian and Amir Sufi's very good new "House of Debt" blog. Sahm summarizes three new research papers on the topic of household deleveraging. The papers address three big questions:

1. When will deleveraging be over?
2. What do households do when they can't repay their debts?
3. Whose decision is deleveraging anyway?

The research on Question 2 is especially interesting:

"Given the increase in mortgage defaults in this recession, it took unusually long (averaging up to 3 years in some states) to go from initial delinquency to a completed foreclosure on a home. During the foreclosure process, households typically lived 'rent free' in their homes. So what did these households do with the extra cash? The authors find a significant improvement in the performance of credit card debt (reduced delinquency and lower balances). Although these households were under considerable financial stress and were already facing a huge hit to their credit scores due to a foreclosure, they used some of the freed up money to pay off their other debts...Normally economists think that if you give cash to households who are financially constrained they will spend it not use it to service debt."

Sahm's overall takeaway from the research she reviews is that:

"There was a big hit to 'permanent income' (households' expected lifetime income and net worth) and credit availability. Thus the level of spending and debt that made sense for households changed dramatically with the recession. Economists already understood this adjustment in the standard consumption framework even if the size and persistence of the shocks have been surprising. So in this sense "deleveraging" is simply a new way to frame the issue rather than a new behavior. And yet, we saw that the debt obligations that households made when everyone thought they were richer could not be easily undone."

Another Fed post worth reading today is a speech, "A Review of the Experience of Fielding the Survey of Consumer Expectations," by James McAndrews. The New York Fed's Survey of Consumer Expectations (SCE) is a relatively new monthly survey of consumers' inflation, labor market, and household finance expectations.

The effort that the NY Fed has devoted to developing this survey is testament to the increasing emphasis economists are placing on understanding the links between expectations and the economy. (This is near and dear to me, as a theme of my dissertation.) Expectations have long played a role in macroeconomic models, but are sometimes treated as an afterthought, probably because they can be difficult to observe and quantify. The SCE includes probabilistic survey questions, which ask respondents to describe their probability distribution over future outcomes. This reveals the uncertainty associated with consumers' expectations.

In the speech, McAndrews delves into some of the nitty-gritty of the multi-year survey development process, which is quite fascinating. He also summarizes the past research using the survey data.

Cab Drivers, Preachers, and Economists' Wives

Lately I have been working on a Great Depression-era economic history paper to constitute one chapter of my dissertation. The practice of writing a history paper is highly enjoyable. It can send you deep into the (thankfully in my case mostly digital) archives. For younger scholars, it is one of the best ways to learn about and reflect on your chosen profession. This can sometimes be quite humorous.

Irving Fisher was a Yale professor and one of the best-known economists of the early 20th century. His weekly Business Page, the closest thing to an economics blog of the time, was widely syndicated in newspapers across the country. His modern day counterpart greatly praises his debt deflation theory, and deservedly so. In addition to good insights, Fisher had many good lines.

The best came at a meeting of the American Academy of Political and Social Sciences in November 1933. Picture Fisher at the podium about to make the closing remarks for the meeting. He begins,

"It is more than fair of the presiding officer to give me not only the first word, but the last word."

(One of the other speakers was a United States Senator, by the way.) Maybe it doesn't take an economist to think this way, but it takes one to speak this way. This is just some relatively benign self-aggrandizement, and a good ego is always good for a good laugh. Another quote, from the 1971 Journal of Money, Credit, and Banking, also made me laugh, but seemed less benign.

"Who among us [economists] has not listened politely to the bizarre theories of the Great Depression as proffered by cab drivers, preachers, and (worst of all) economists' wives? One simply learns to avoid cabs, churches, and home each time the Grapes of Wrath makes one of the film festivals or books by Studs Terkel about Huey P. Long make the best-seller lists."

Fisher only asserts his superiority to other economists and politicians, whereas this economist asserts economists' intellectual superiority to the public at large, or at least its female and service professional components. "Isn't it cute when our wives try to understand the economy? Aren't we great for being so polite to the poor dolts?"

Now, the vast majority of economists I know today have the utmost respect for their spouses' intellects. What we should avoid at all costs is a "polite" disregard of the intellect of the general public. Economists shouldn't "avoid cabs, churches, and home." Cabs, churches and home are the economy. (And I can think of one particular preacher whose vision of economics will not be ignored.) Economic policy would function more smoothly if more people understood it. In a democracy, people deserve the chance to understand the economy and economic policies that affect their lives. This is put really well by Alan Blinder and coauthors (2009), regarding monetary policy:

"It may be time to pay some attention to communication with the general public...In the end, it is the general public that gives central banks their democratic legitimacy, and hence their independence."

This is also why I really respect efforts like those of Annamaria Lusardi to teach economic and financial literacy to the public under the assumption that everyone is capable of understanding, so long as they are given the opportunity to learn.

Long-Term Unemployment and the Dual Mandate

The Federal Reserve's mandate from Congress, as described in the Federal Reserve Act, is to promote "maximum employment, stable prices, and moderate long-term interest rates." In January 2012, the FOMC clarified that a PCE inflation rate of 2% was most consistent with the price stability part of the so-called "dual mandate." The FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy says:

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

Lately, PCE inflation has been well below 2%. There is no similarly-specific definition of maximum employment, but I think it is safe to say that we are not there yet. So we seem to be in a situation in which the objectives are complementary--employment-boosting policies that also put some upward pressure on prices would get us closer to maximum employment and stable prices at the same time. This is supposed to be the "easy case" for monetary policymakers, earning the name "divine coincidence." The tougher case would come if inflation were to get up to or above 2% and employment were still too low. Then there would be a tradeoff between the employment and price stability objectives, making the Committee's balancing act more difficult.

San Francisco Federal President John Williams presents the case that the rise in the share of long-term unemployment should affect the approach that Committee members take when faced with such a balancing act. Williams and SF Fed Economist Glenn Rudebusch have a new working paper called "A Wedge in the Dual Mandate: Monetary Policy and Long-Term Unemployment." In this paper, they document key empirical facts about the share of long-term unemployment and explain how it alters the relationship between employment and inflation.

Source: Rudebusch and Williams 2014, p. 4.

First, the key empirical facts about long-term unemployment share in the U.S.:

1. It has trended upward over the past few decades.
2. It is countercyclical.
3. Its countercyclicality has increased in recent decades.

Fact 1 has been attributed to the aging population, women's rising labor force attachment, and increasing share of job losses that are permanent separations rather than temporary layoffs (Groshen and Potter 2003, Aaronson et al. 2010, Valletta 2011).

The long-term unemployed appear to place less downward pressure on wages and prices than the short-term unemployed. This may be because the long-term unemployed are less tied to the labor market and search less intensely for a job as they grow discouraged (e.g., Krueger and Mueller 2011). Stock (2011) and Gordon (2013) find that distinguishing between long- and short-term unemployment can help account for the puzzling lack of disinflation following the Great Recession. Rudebusch and Williams find a similar result by running Phillips Curve regressions that include short-term and long-term unemployment gaps as regressors. Only the coefficient on the short-term unemployment gap is negative and statistically significant, implying that short-run unemployment exerts downward pressure on prices while long-run unemployment does not.

The finding that long-term and short-term unemployment have different implications for price dynamics is very relevant for the Fed's pursuit of its dual mandate.  When the long-term unemployment share is high, this introduces a "wedge" between the employment and price stability portions of the mandate. Employment and inflation won't be as prone to moving in the same direction, because employment can get very low without much downward pressure on wages (and prices). To formalize what this means for monetary policy decisions, Rudebusch and Williams build a stylized model economy (skip ahead if not interested in the details) in which the central bank's objective is to minimize a quadratic loss function:
\begin{equation}
L=\tilde \pi + \lambda \tilde u,
\end{equation}
where pi tilde and u tilde are deviations of inflation from its target and unemployment from the natural rate, and lambda is the weight that policymakers place on unemployment stabilization versus inflation stabilization. Let the unemployment deviation depend on a demand shock v and the deviation of the short-term interest rate from the natural rate (IS equation):
\begin{equation}
\tilde u = \eta \tilde i + v
\end{equation}
 Let deviations in inflation depend on an inflation shock e and the deviation of the short-run unemployment rate s from its natural rate:
\begin{equation}
\tilde \pi = -\kappa \tilde s + e
\end{equation}
The short-run unemployment rate is a fraction of the overall unemployment rate u,
\begin{equation}
s=\theta u,
\end{equation} where
\begin{equation}
\theta=\bar \theta -\delta \tilde u + z,
\end{equation}
where z is a shock to the short-run unemployment share. If we substitute these equations into the loss function and take first order conditions, we arrive at an expression for the optimal deviation of inflation from its target:
\begin{equation}
\tilde \pi*=\frac{\lambda}{\lambda+\kappa^2 \theta^2}e-\frac{\lambda \kappa \bar u}{\lambda+\kappa^2 \theta^2}z
\end{equation}

The first thing to notice here is that the demand shock v does not show up in the optimal policy decision. This is the divine coincidence-- demand shocks impose no tradeoff between the employment and inflation objectives.

The second thing to notice is how the inflation shock e and the short-run unemployment share z. The first term is standard, and shows how the optimal policy partially offsets a positive (negative) inflation shock by raising (lowering) unemployment. The other term is new to this paper. A positive shock to theta acts like a negative inflation shock in the sense of prescribing a higher short-run unemployment rate and lower inflation rate. Another policy implication arises because theta affects the slope of the Phillips curve with respect to aggregate unemployment. This creates an asymmetry in the optimal policy response to inflation shocks that depends on theta.

During the Great Recession, the short-run unemployment share theta reached historic lows. Rudebusch and Williams simulate their model starting in the first quarter of 2014, using actual data from 2013 as initial conditions. They compare the optimal policy response implied by their model to that implied by a standard model (i.e. one that does not distinguish between short-run and long-run unemployment). The figure below displays the results. The quantitative results are not meant to be taken too seriously, since the models involve drastic oversimplifications, but the qualitative differences are  illustrative.The model that distinguishes between short-run and long-run unemployment (shown as black lines) prescribes a higher inflation rate--temporarily above 2%--than the standard model (shown as dashed red lines).

Source: Rudebusch and Williams 2014, p. 22

The authors conclude (emphasis added):

During the recent recession and recovery, the number of discouraged jobless excluded from the unemployment rate and the number of part-time employees wanting full-time work have reached historic highs. If the true measure of labor underutilization included these individuals, even though they have little or no eff ect on wage and price setting, then the wedge in the Fed's dual mandate would be even wider. Based on the analysis in this paper, the implications are clear: Optimal policy should trade off a transitory period of excessive inflation (beyond what is calculated using this paper's model) in order to bring the broader measure of underemployment to normal levels more quickly.

This is a very interesting and intuitive result, and is highly relevant to the policymaking environment in both the United States and elsewhere, particularly Europe. However, I'm not sure that the FOMC as a whole will take this paper's implications seriously. The committee does not share a single "loss function" like the quadratic function presented in the paper, which treats overshooting and undershooting of the inflation target symmetrically. Mark Thoma's comment on the paper is, "I'll believe the Fed will allow *intentional overshooting* of its inflation target when I see it."

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.