While Stanley Fischer defended central bank discretion, John Williams, of the San Francisco Fed defended a change in the monetary framework and strategy, arguing for a change in the monetary policy target, from inflation targeting to price level targeting:
It’s been said that “getting over a painful experience is much like crossing monkey bars. You have to let go at some point in order to move forward.”
Now that we’ve gotten the monkey of the recession off our backs, we have the luxury of being able to look to the future. This presents us with the opportunity to ask ourselves whether the monetary policy framework and strategy that worked well in the past remains well suited for the road ahead.
There’s a buzzword in the world of emergency response: resiliency. You can’t predict precisely when or where the next storm will arrive, or exactly what it will look like. But you can make yourself resilient, so when the time comes, you’re ready and able to limit the damage and recover quickly.
We need to think of our resiliency toward the next economic storm in the same terms. Although an inflation-targeting framework has served central banks across the globe well in the past, the world has changed in ways that call into question its efficacy going forward. In particular, there is mounting evidence that the natural rate of interest, or r-star, in the United States and elsewhere has fallen to historic lows, which hampers the ability of conventional monetary policy to respond to the next downturn.
As I have argued before, in the best of all worlds, fiscal and other policies would be put in place that propel long-run economic prosperity and boost r-star on a sustained basis. Absent such actions, monetary policy will be severely challenged to achieve stable prices and strong macroeconomic performance in a low r-star world. Therefore, now is the right time to examine whether monetary policy frameworks must adapt to changing circumstances.
There are a number of potential alternative strategies to cope with a low natural rate of interest, including regular reliance on unconventional policy tools, negative interest rates, and raising the inflation target. Each of these have various advantages and disadvantages.
In my remarks today, I’ll narrow the focus to one alternative policy framework that deserves particular attention because it offers significant advantages over inflation targeting, particularly in a low r-star world: flexible price-level targeting.
He then mentions the “unfathomable parameters” and indicates that price level targeting is a better target where “unfathomable parameters” rule:
Underlying constants like potential GDP, the natural rate of unemployment, and the natural rate of interest are not really constant: They change over time in unpredictable ways. Monetary policy has proven most successful when it has been able to account for these changes.
Although the natural rate of interest is the topic du jour, the challenges for monetary policy to adapt to uncertain and changing natural rates is not new. In a series of research papers, Athanasios Orphanides and I investigated the design of robust monetary policy strategies that can succeed in the face of real-world uncertainties, including about the natural rates of interest and unemployment.
To be precise, we studied what is called a “difference” monetary policy rule. This type of policy strategy is closely related to a version of the Taylor (1993) policy rule, but with the main difference that policy responds to deviations of the level of prices relative to a steadily growing target level, rather than deviations of the inflation rate from a target rate.
One recurring finding of our research is that a policy strategy that targets the price level in this way and responds to the unemployment rate can be highly effective at stabilizing both inflation and unemployment in an environment of structural change and uncertainty.
In a nutshell, the big advantage of this approach is that any surges or drops in the inflation rate need to be made up in the future. This assures that, over the medium term, inflation stays on track, even if policymakers have a very imperfect understanding of the levels of natural rates or other structural changes affecting the economy.
My first question: How can a strategy that targets the price level can also, independently, respond to the unemployment rate?
Imagine a situation where the increase of the price level above the trend path (a positive deviation of the level of prices) occurs simultaneously with a rise in the unemployment rate. This combination results from a negative supply shock. If the central bank tries to bring the price level back to the trend path, it will certainly worsen the unemployment picture. What to do?
That´s the main problem with a price level targeting monetary policy strategy. It will cause instability when supply shocks occur. A better level target strategy is to target the level of NGDP (or nominal spending) along a steadily growing path.
The charts show that during the great moderation, the Fed could have been implicitly targeting either the price level or NGDP. They are “observationally equivalent”. However, when the supply shock, in the guise of a rapid and large increase in oil prices, hit, “the price level dog” barked up the wrong tree. Not so the” NGDP dog”.
If the Fed had been level targeting NGDP it would have avoided the strong drop in economic activity and the steep rise in unemployment.
That problem was also evident if the strategy had been inflation targeting, especially if the Fed concerned itself with the headline version, as it did. If it had payed attention to the core version, it would have seen that the inflation trend did not change, in which case monetary policy would not have reacted.
It´s interesting to see that the most frequent criticism of NGDP level targeting is that the numbers are subject to revision. Stanley Fischer writing in 2013 provides an example:
There are those who support setting a nominal GDP target. I think that this is very impractical. The data that we receive on nominal GDP are very unstable. There are changes of whole percentage points between the various estimates of GDP. For this reason, I think that there is no reason to use nominal GDP as a target.
What about those “Unfathomable parameters” used to guide monetary policy, which are unknown?
Ironically, as Governor of the Bank of Israel from 2005 to 2013, Stanley Fischer (managed) to keep NGDP growing at a stable rate along a level path!
As he wrote in 1995:
“Because a supply shock leads to higher prices and lower output, monetary policy would tend to tighten less in response to an adverse supply shock under nominal-income-targeting than it would under inflation-targeting. Thus nominal-income-targeting tends to imply a better automatic response of monetary policy to supply shocks”.
Did he really change his mind so drastically, or is it something else that´s influencing his new, critical, argument?
Keeping in mind that central bankers are loath to admit mistakes (for a 1937 example see here, pages 11-12)), why should Fischer open his flank to criticism by reaffirming that NGDP targeting would have been better, as witnessed by him in Israel as shown in the charts below?