Price Level targeting would not have avoided disaster in 2008

Raphael Bostic, Atlanta Fed president, is arguing for a change in the monetary policy framework, from inflation targeting (IT) to price level targeting (PLT) See here, here.& here.

What I want to show is that, although PLT differs from IT in that PLT has a “memory”, it suffers from the same weakness, i.e. it is sensitive to supply (for example, oil) shocks. In addition, I argue that an alternative monetary policy framework, NGDP level targeting, also has memory but does not suffer from the supply shock sensitivity of PLT.

Ten years ago, the FOMC was “laser focused” on inflation. In the June 2008 meeting, for example, we read in the transcript that:

Despite this recent news, we expect inflation to rise sharply over the next few months. In part, this reflects our judgment that core prices were held down in the first half by some factors that will not persist into the second half [the “transitory” argument was already a favorite]. In addition, we expect increases in food and energy prices to push up the twelve-month change in the total PCE price index more than 1 percentage point over the next several months, to about 4½ percent.

Regarding inflation, every single participant, with the possible exception of Mishkin, showed grave concern. This is reflected in Bernanke´s summary:

My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant.

We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. 

When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.

This is the picture:

Would the worry be different if instead of IT, the Fed pursued a PLT? The next picture shows probably not.

The reason for the rise in both inflation and the price level relative to trend was a strong and quick increase in oil price (an oil shock).

Ironically, the Fed´s worry about oil (and food) prices in June 2008 happened when those prices topped! In the first two charts, both inflation and the price level relative to trend drop significantly with the fall in oil prices.

Getting help from the Dynamic Aggregate Demand (AD)-Aggregate Supply (AS) model (DADAS)

That model tells us that when there is a supply shock, the AS curve shifts up and to the left, increasing inflation (or the price level relative to trend) and reducing real growth.

The first two charts above show that inflation and the price level increased on the heels of the supply shock depicted in the third chart. Chart 4 shows that real growth decreased.

In chart 3, we observe that after June 2008, oil prices dropped back to their initial value. This is a positive supply shock that, according to the DADAS model, would decrease inflation and increase real growth.

In charts 1 and 2 we see that inflation and the price level (relative to trend) fall. Real growth, however, plunges. That pattern is consistent with a massive negative AD shock.

The NGDP Level chart 5 shows that during the oil shock, NGDP dropped below the trend path. In other words, monetary policy was being tightened (although the FFR fell). Then, the Fed “cranks the monetary screws” and real growth and inflation plunge.

If the Fed had kept NGDP evolving close to trend, the recession would not become “great”. More importantly, the economy would not have remained depressed for the past 10 years.

As Scott Sumner put nicely:

Economists are beginning to understand that NGDP is the variable we should actually be concerned about. Instead of worrying about what might happen to inflation under NGDP targeting, we should consider what happens to NGDP if we insist on targeting inflation.

Interestingly, in 2004-06, the economy was also buffeted by an oil shock.

Variables behave in accordance with the predictions of the DADAS model:

Headline inflation rises (and falls when oil price drops)

And real growth falls.

The difference in the two episodes is evident in what happens to the unemployment rate.

In the early period, unemployment falls from the lofty level reached after the 2001 recession. In the latter period, unemployment begins to rise gently from a low level, and suddenly balloons.

The contrasting behavior of unemployment in a similar environment (oil price shock), is explained by the contrasting behavior of NGDP.

While in the early period NGDP remains close to the trend level path, in the latter period it slowly falls below trend before plunging.

Throughout those years, and despite the back-to-back inflation shocks, core PCE inflation remained tame, averaging a little below 2.1%.

Bottom Line: NGDP Level Targeting does not give rise to the very high social costs in terms of unemployment that can come from IT or PLT.


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