An alternative to inflation targeting?

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. Rather than target a rate of inflation, as is now custom, target a level of prices.

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.

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 [3% to 6% in South Africa]. 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.


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.

One problem with this approach is what happens to real interest rates – 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 – which play an important role in driving business and household decisions about spending and investing – 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’s only so much a central bank can promise without sacrificing its credibility.

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’t the rate of inflatoin, it’s a price index, like a consumer price index.

Let’s 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’s 102 plus a 2% inflation rate.) To get there, the central banker has to make up for the previous year’s 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’t get punished for running too hot for a little while.

One problem with the idea is that central banks don’t 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 would be a communications challenge for central bankers.

Source: Wall Street Journal

Also see the post, Inflation targeting in the West