Ricardo Reis on price level targeting
By Scott Sumner
I’ve devoted much of my life to promoting market-based approaches to monetary policy. To better understand the idea, let’s start by assuming the goal is simply a stable price level. Since the value of base money is the inverse of the price level, there are two ways that the price level can be stabilized.
1. Give market participants an incentive to move the supply of base money to the level expected to promote stable prices.
2. Give market participants an incentive to move the demand for base money to the level expected to promote stable prices.
I believe supply of money approach was first advocated by Earl Thompson in 1982. Thompson’s (never published) paper is one of the 5 most important macro papers of the past 100 years, and almost no one has heard of it.
I’ve also done work in this area, as have a number of other researchers including David Glasner, Kevin Dowd, Robert Hetzel and Bill Woolsey. John Cochrane advocated something similar in 2010.
Robert Hall pioneered the second (demand for money) approach in 1983 (in the Journal of Monetary Economics). In Hall’s proposal, bank reserves earn interest, and the interest rate is indexed to the price level. This means that the demand for bank reserves rises when banks expect inflation, and falls when banks expect deflation. Because rising money demand is deflationary, and vice versa, these shifts in money demand will automatically tend to stabilize the price level.
Cloud Yip has a series of interviews called “Where is the General Theory of the 21st Century?” In the comment section of a recent post where I criticized interest on reserves, Cloud directed me to a very interesting interview of Ricardo Reis, and suggested that I focus on this passage:
Q: In brief terms, how can the proposed payment on reserve process help central banks achieve the targeted price level?
R: The intuition is as following: the reserve is a very special asset that has one particular property – reserves are the unit of account in the economy. One dollar of reserves defines what the dollar is. It is one unit of deposit in the central bank that defines what a dollar is.
People of course more used to thinking, “Oh no! It’s the piece of paper with some printing of the queen that defines what a pound is!” But remember those pieces of paper are nothing but something that exchanges one to one with reserves in the central bank. So, reserve is the unit of account of the economy. One unit of reserve always worth one dollar.
Now imagine that instead of promising to pay them the nominal interest rate, you promise that the interest rate, i.e. the remuneration of the reserves, is indexed to the price level. So, in de facto, the reserve essentially pay a real payment in the same way that the inflation-indexed government bonds do. There is no barrier to doing this. After all, it is the same way government issued the inflation-indexed bonds, so can the central bank.
The central bank can say that, instead of paying 3% of nominal interest on reserve, it will pay 3% times the price level tomorrow. If it does that, note that central bank is promising a real payment tomorrow to whoever hold the reserve.
On the other hand, there is a real interest rate pinned down in the economy that has to do with investment opportunities and how impatient people are. If the central bank promises a real payment, under the no-arbitrage condition, this pinned down the real value of the reserves today, as the real payment tomorrow divided by the real value today is equal to the real return.
The payment on reserve pinned down the real value of reserve today. And back at the beginning, we realized that the reserve is worth a dollar. So, if we have pinned down the real value, what also have we pinned down? We have pinned the price level. This is because the real value of one dollar of reserves is precisely given by the price level.
So, by choosing this remuneration of reserves, and making it a real payment indexed to the price level, you have de facto pinned down the real value of reserve today, which is nothing but the price level.
The last paragraph makes the outcome seem a bit more tautological than it actually is, but Reis is basically right. This sort of system would automatically stabilize the expected future price level. You could replace the FOMC with a computer. Unless I’m mistaken, this is essentially Hall’s 1983 proposal.
You could also think of it as being sort of like the gold standard, except for two differences:
1. Instead of dollars being redeemable into 1/35 oz. of gold, they are redeemable into a fixed basket of goods and services.
2. The redemption applies to bank reserves, and guarantees that one dollar in reserves can be redeemed a year from today for enough dollars to buy one plus the real interest rate worth of goods and services.
Thus if the real interest rate today is 3% (say on one year TIPS), and if prices were to rise 1% above target over the next year, holders of reserves would receive 4% interest on their deposits at the Fed.
Of course if people expected prices to rise 1%, then the expected return on reserves would exceed the return on TIPS, the demand for reserves would rise, and this would automatically restrain the rise in prices.
Today, only banks can deposit money at the Fed, but if we are serious about this system then it makes sense to allow the general public to also have deposits at the Fed. The more the merrier when it comes to the “wisdom of crowds”.
I still slightly prefer the supply of money approach pioneered by Thompson, because the zero interest rate lower bound (which might be more like minus 1%) can create problems for monetary policies that rely on adjusting the interest rate on reserves, rather than the quantity of reserves. Even so, I’d strongly support Reis’s proposal as a sort of second best option, as long as the policy goal was shifted from a stable price level to a gradually rising NGDP.
Both of these market-based approaches to policy, the Thompson supply of money approach and the Hall demand approach have survived on the fringes of macroeconomics for many decades. Every so often an elite mainstream economist like Reis or Cochrane rediscovers the idea. I believe that we are about 10 years away from this approach going mainstream, and becoming an important part of macroeconomics.
PS. Here is a Tyler Cowen post on the colorful Earl Thompson, and here is his picture:
A decade from now the profession will still be trying to catch up to his 1982 paper.