{"id":348103,"date":"2010-02-21T22:34:51","date_gmt":"2010-02-22T03:34:51","guid":{"rendered":"http:\/\/blogs.wsj.com\/economics\/2010\/02\/21\/an-alternative-to-the-2-inflation-goal\/"},"modified":"2010-02-21T22:34:51","modified_gmt":"2010-02-22T03:34:51","slug":"an-alternative-to-the-2-inflation-goal","status":"publish","type":"post","link":"https:\/\/mereja.media\/index\/348103","title":{"rendered":"An Alternative to the 2% Inflation Goal"},"content":{"rendered":"

There could be a better alternative to inflation targeting, which became all the vogue among central bankers in the last two decades but now has doubters<\/a>. \u00a0Rather than target a rate of inflation, as is now custom, target a level of prices.<\/p>\n

Price level targeting, its proponents say, would give central banks more flexibility to respond aggressively to downturns and crises without sacrificing their inflation fighting credibility. When inflation undershoots during a recession, it would allow the central bank to run the economy hot and allow inflation to overshoot for a while in a recovery.<\/p>\n

First a little background. Many central banks now target a rate of inflation. The Federal Reserve, for instance, has an informal goal of 1.5% to 2% inflation over the long run. Targeting became popular in the 1990s and 2000s because central bankers felt it helped build their inflation fighting credibility, which anchored expectations for future inflation, kept interest rates low and helped to keep the economy robust and stable.<\/p>\n

But there are problems with this approach. One is that it forces central bankers to lose their memory. Say inflation falls short of a 2% target one year — as it did in many places last year. A strict adherent to an inflation rate target would let bygones be bygones and continue to target 2% inflation in year two, even though the economy is coming out of recession with slack and excess capacity.<\/p>\n

One problem with this approach is what happens to real interest rates \u0096 meaning interest rates adjusted for inflation — in a severe downturn. Say the Fed has pushed interest rates to zero and inflation goes negative in a downturn. Real interest rates \u0096 which play an important role in driving business and household decisions about spending and investing \u0096 would actually be higher. One solution to the problem would be to promise higher inflation in the future, but with a 2% inflation rate target, there\u0092s only so much a central bank can promise without sacrificing its credibility.<\/p>\n

Now imagine a world with the price level targeting twist. In this world, the central banker still wants inflation to average 2% over the long run. But his target isn\u0092t the rate of inflatoin, it\u0092s a price index, like the consumer price index.<\/p>\n

Let\u0092s say in year one the index is 100. Then say a shock hits in year two and inflation undershoots the target of 102 and instead comes in at 101. In year three, the target is 104 and change (in other words, it\u0092s 102 plus a 2% inflation rate.) To get there, the central banker has to make up for the previous year\u0092s underperformance, and has to instead deliver 3% inflation, running the economy a little hotter than normal as it comes out of recession. In this world, real interest rates would be a little bit lower than they are in the world in which inflation rates are targeted. But if the public believes the central bank is committed to its goals, the central bank doesn\u0092t get punished for running too hot for a little while.<\/p>\n

Kenneth Kuttner, a Williams College economist, says he used to be skeptical of the idea. But it\u0092s starting to win him over. If you\u0092re hit by a really bad shock, he says, \u0093you want to get inflation expectations up\u0094 to avoid a deflationary spiral. This kind of approach, which promises more inflation after a big economic shock and less when an economy is running hot, helps to do that.<\/p>\n

One problem with the idea is that central banks don\u0092t have experience with it. Besides an experiment by Sweden in the 1930s, it is untested. Another is that it would be hard to explain. Bond investors are used to watching monthly readings of inflation rates and the public is used to headlines that focus on rates. Convincing the public to start focusing on some obscure index level [Trivia question: Where is the CPI index today?] would be a communications challenge for central bankers.<\/p>\n

George Kahn, a researcher at the Federal Reserve Bank, looked at the idea and concluded central banks aren\u0092t likely to adopt the idea \u0093without considerable further research or a dramatic deterioration in economic performance.\u0094 http:\/\/www.kc.frb.org\/PUBLICAT\/ECONREV\/pdf\/09q3kahn.pdf<\/a><\/p>\n

But don\u0092t be surprised if you haven\u0092t heard the end of this idea as the economics profession rethinks what went wrong in the great economic crackup of 2008 and 2009.<\/p>\n

Here\u0092s some more reading on the subject, courtesy of Professor Kuttner:<\/p>\n