John Williams suggests an alternative monetary policy framework

His argument:

Potential output—the maximum amount an economy can produce over the long run—is an important indicator policymakers use to gauge a country’s current economic health and expectations for future growth. However, potential output can’t be observed directly, and estimating it is difficult, even with modern, sophisticated methods. Monetary policymakers are well advised to account for the perennial problem of uncertainty surrounding these estimates in devising and carrying out policy strategies.

He suggests an alternative:

In light of the reality that measuring potential output is very difficult despite the best efforts, it pays to avoid overreliance on these estimates when possible. In particular, there has been considerable research on the problem of conducting monetary policy with imperfect estimates of potential output or the full-employment level of unemployment (Williams 2017).

One recurring finding of this research is that a policy strategy that targets the price level and responds to the unemployment rate can be highly effective at stabilizing both inflation and unemployment when policymakers are uncertain about the economy’s potential (Orphanides and Williams 2002, 2013).

In a nutshell, the big advantage of the price-level targeting approach is that swings 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 potential output or other structural changes affecting the economy.

However, the idea that “swings in the inflation rate need to be made up in the future” is a problem when the swings in inflation reflect (positive or negative) supply shocks.

The chart shows that overall, targeting inflation has been quite successful, at least when you consider the core version of the PCE inflation to represent your target. Note that prior to January 2012, the inflation target was “keep inflation low and stable.”

Inflation in recent years has not been markedly different from what it was during the second half of the 1990s and early 2000s, so why the “stress”? Simply because now there is an explicit numerical value for the target.

How would the Fed have acted if it were targeting a price level?

The back-to-back oil price shock in 2005-08 would have required the Fed to raise rates, which would have made the 2007 recession even “greater”.

Conversely, when the economy is buffeted by a positive (productivity) shock, the Fed would be required to “ease”.

The result, in both cases is nominal instability, increasing the variability in both inflation and output.

What, then, would characterize a robust monetary-policy regime? Based on the examples above, it would be one that does not respond to supply shocks, but does vigorously respond to demand shocks (and one that does not “automatically” generate demand shocks).

The problem with an inflation targeting, or even price level targeting central bank is that it has a hard time ignoring supply shocks because they move inflation.

The central bank should only respond to inflation caused by demand shocks, but it is hard to distinguish the source of inflation movements in real time. One way to get around this problem is to directly target demand itself. That is, the Federal Reserve could aim to stabilize the growth of total dollar spending. This way the Federal Reserve would not have to worry about divining the sources of movements in inflation.

If the Federal Reserve directly targeted the level  of total dollar spending, or NGDP, it would by default be allowing the price level to move inversely with productivity-driven or oil price-driven changes in real GDP. This would amount to a monetary-policy regime that ignores supply shocks.

Therefore, ignoring supply shocks means allowing such shocks to be reflected in relative price changes. Ignoring supply shocks also means allowing market interest rates to more closely track the market-clearing or neutral-interest-rate level. Doing so reduces financial instability.

The chart shows that if the Fed were targeting the level of total dollar spending, or NGDP in 2007-08 it would be receiving signals that monetary policy was too tight, the opposite of what happened if it were targeting headline inflation or the price level.

The outcome would have been much less painful and the economy would have not gone near the ZLB.

Bottom line: An NGDP level target provides a much better monetary framework than Willims´price level target.


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