Under Mr Bernanke’s proposal of price level targeting, when the federal funds rate is at the zero lower bound, the central bank would be accountable for past inflation misses relative to the 2% target. It would no longer have the discretion to neglect past deviations and would need to make up for past misses. To illustrate, Mr Bernanke depicts the path of core PCE price level since the December quarter 2008 – when the federal funds rate hit the zero lower bound – against a counterfactual price level that grows at the 2% target (see chart). At present, the actual price level stands at 13.8% higher than 4Q2008, below the the 2% target trend which has grown by 19%. The cumulative miss amounts to over 400 basis points. Under the proposed new framework, the Federal Reserve would vow to maintain the federal funds rate at zero until the price level makes up for the past cumulative shortfall.
For argument’s sake, suppose that the federal funds rate was still anchored to zero. The central bank would then promise to hold its policy rate at this level until the core PCE price level rises by no less than 400 basis points relative to the target price level (bearing in mind that the target continues to grow around 0.5% per quarter).
A debate on a price level targeting regime represents a welcome development in the direction of what market monetarists advocate; a framework that targets the level and/or growth of an aggregate income measure, notably nominal GDP. Nominal GDP has a number of desirable properties relative to overall prices. First, nominal GDP is a better measure of economic well-being because households earn nominal wages and business earn nominal profits. Second, it is not subject to the same mis-measurement issues as overall prices or inflation. Third, demand shocks – which central banks ought to focus on – are better reflected in changes to nominal GDP than prices. Fourth, households mistakenly believe that low inflation is desirable because they focus on what they buy and not what they sell, notably their labour (a point highlighted by market monetarist, Scott Sumner).
Against this backdrop, Evidente has developed an alternative policy measure that focuses on deviations from a target level of nominal GDP. To that end, I have estimated a target trend for the United States based on the period 1993 to 2008, and extrapolated this trend out to 2017. At present, the shortfall amounts to 20%; the economy’s counterfactual nominal GDP would be 20% higher if it had grown since 2008 at the same trend rate posted from 1993 to 2008 (see chart). The shortfall has continued to grow and at present, is at its highest level. This framework would suggest that the Federal Reserve should have waited longer before embarking on its tightening process.
Mr Bernanke’s paper represents the start of what is a likely to be a drawn out debate about monetary policy and what it ought to target. Whatever the new central bank standard looks like in the future, one that incorporates level targeting and makes up for past deviations from target would amount to a significant enhancement on the current inflation targeting standard, particularly if policy rates remain close to the zero lower bound for an extended period.
Finally, the price level gap outlined by Mr Bernanke and the nominal GDP level gap reported here contain potentially valuable incremental information about the stance of monetary policy above and beyond real or inflation adjusted policy rates. Evidente is currently working on developing a framework that utilises this information to improve measures of expected returns at the market level. In due course, these measures are likely to become an indispensable part of the toolkit just not for central bankers, but also for asset allocators.
Sam writes as a freelance journalist for The Age, Sydney Morning Herald and Australian Financial Review, was a member of the advisory board of API Capital, teaches business finance and international finance courses to undergraduates at RMIT, and most importantly Sam is a well respected source of information and friend of TAMIM.