Who's afraid of level targeting?
By Scott Sumner
Ken Duda directed me to a speech by Stanley Fischer, which lays out four options for the next time rates hit zero:
1. Negative interest on reserves
2. A higher inflation target
3. Fiscal stimulus
4. Abolition of currency
It’s disappointing to see no mention of the most powerful tool for addressing the zero bound, level targeting. That’s not just my view, but also the view of prominent New Keynesians like Michael Woodford. And it was also the view of Ben Bernanke back in June 2003. The following is from the transcript of one of Bernanke’s first FOMC meetings:
What I think has been missing from the discussion we have had here today so far is that working on expectations of future short-term interest rates can be done through a comprehensive package. There are many different ways to approach expectations management. One is communications of the type we’ve been doing through our statements. There are various targeting procedures for inflation or price level targeting. Eggertson and Woodford talk about some reasons for price level targeting, which is their favorite approach.
Lawrence Ball wrote a paper claiming that Bernanke’s views were immediately shot down at that meeting, and that after that time Bernanke switched to the Fed’s internal views of policy, which most certainly did not involve level targeting:
Sections IV-VI review the broader evolution of Bernanke’s views. I find that they changed abruptly in June 2003, while Bernanke was a Fed Governor. On June 24, the FOMC heard a briefing on policy at the zero bound prepared by the Board’s Division of Monetary Affairs and presented by its director, Vincent Reinhart. The policy options that Reinhart emphasized are close to those that the Fed has actually implemented since 2008; Reinhart either ignored or briefly dismissed the more aggressive policies that Bernanke had previously advocated.
In the discussion that followed the briefing, Bernanke joined other FOMC members in agreeing with most of Reinhart’s analysis.
So why is the Fed so opposed to level targeting, when outside economists (including me) find the idea so appealing? Perhaps because it would radically change the nature of monetary policy. The Fed talks a lot about “targeting” inflation, but it never really takes ownership for changes in the value of money. It makes gestures toward easier or tight money, but doesn’t commit to make up for any shortfalls over overshoots.
If you still have trouble seeing why the difference between growth rate and level targeting is so important, consider that under level targeting it would no longer make sense to think in terms of policy hawks and doves, as the long run rate of inflation (or NGDP growth) would not be affected by today’s decision. If a hawk succeeded in lowering inflation to 1% this year (under a 2% level target), then the Fed would have to shoot for 3% next year. In other words, the low inflation would be a Pyrrhic victory for policy hawks, and hence there’d be no point in being a hawk.
Now suppose the Fed doesn’t want to be forced to shoot for 3% inflation, whenever they undershot with 1%. Suppose they don’t want the press constantly pointing out that any gap between the actual price level and the target path is the Fed’s fault. Under growth rate targeting they can always point to temporary shocks, unexpected events. “It’s not our fault.” That won’t work under level targeting. Under level targeting, the Fed would have had to have been far more expansionary after 2008, and they apparently didn’t want to be far more expansionary.
Last time there was a big gap between central banks and leading theorists was during the 1920s, when the leading theorists favored price level targeting (or NGDP targeting in a few cases) and the central banks favored the gold standard. We now know that the leading theorists were correct. It will be interesting to see who ends up being right this time.
I wasn’t at the recent AEA meetings, but I’m told there was lots of discussion of how income inequality reduces aggregate demand. Combine that depressing tidbit with the fact that grad schools no longer teach macroeconomic history. Here’s macroeconomics, described by one of my favorite artists: