"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Friday, March 26, 2010

Donald Kohn - don't blame me for the crisis, blame science instead. And price level path targeting doesn't work, because third grade math problems will leave people perplexed

Fed vice chairman Donald Kohn thinks that the end of Great Moderation was caused by bad science:
"More study leading to a better understanding of the linkage between central bank actions and expectation formation should improve the ability of central banks to achieve society's inflation and output objectives more effectively under a variety of circumstances, including in a severe negative shock of the type we recently experienced."
In the earlier part of his speech it becomes clear that the problem is not with the linkage between central bank actions and expectations, but with central banks themselves:
"Given the severity of the downturn, it became clear that lowering short-term policy rates alone would not be sufficient."
If the key problem is central banks that were asleep at the wheel, should central banks correct their driving mistakes? According to Kohn, no, because third grade maths are two complicated:
"Another approach to this problem is for central banks to target a gradually rising price level rather than a constant inflation rate. Imagine a plot of the consumer price index (CPI) from today onward increasing 2 percent each year. Central banks would commit to adjusting policy to keep the CPI near that line.

The advantage of this approach, in theory at least, is that when a negative shock drives prices below the target level, people will automatically expect the central bank to increase inflation for a while to get back to trend. In principle, that expectation would lower real interest rates without the central bank changing its inflation commitment, even if nominal interest rates were pinned at zero. It could also make it easier for people to make long-term economic decisions because they could anticipate that inflation misses would be reversed over time, reducing uncertainty about the future price level.
While I appreciate the elegance of this price-level-targeting idea, I have serious doubts that it would work in practice. Central to the idea is that the Federal Reserve would be committing to hit a price level that was growing at a constant rate from a fixed point in the past. The specific inflation rate that could be expected in the future would change over time, depending on the inflation that had been realized up to that point. You could know what inflation rate to expect only if you knew both the current consumer price index and the Fed's target for the index in the future. In addition, the inflation rate that you could expect would be different for different horizons. Moreover, central banks are able to control inflation only with a considerable lag and even then only imprecisely, so the process of hitting a target would likely involve frequent overshooting and correction and consequently frequently shifting inflation objectives.

Contrast this approach with the communications required of central banks when targeting a specific inflation rate. For example, central banks targeting a 2 percent inflation rate typically put that target prominently on their webpage. If those banks were instead targeting a price level growing at 2 percent, their webpages would have to provide a table of inflation rate targets for a variety of horizons, and the targets would change each month. I fear that rather than anchoring people's expectations about prices, it could leave them perplexed."

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