New research published Thursday suggests the Federal Reserve’s inflation target is inadequate because of its inability to deal with large supply and demand shocks.
“Inflation targeting should, therefore, be replaced with a more robust monetary policy regime: one that ignores supply shocks, but responds vigorously to demand shocks,” David Beckworth said in a paper published by the Mercatus Center at George Mason University.
The Federal Reserve has used inflation targeting for some time and in the early 1990s adopted an implicit target. In January 2012, with the economy not recovering as fast as policymakers would have liked, the Fed adopted an explicit 2.0-2.5% target and since then, the lower end of 2% has been widely considered the target.
“Central banks should directly target only demand by stabilizing the growth of total dollar spending in the economy instead of focusing on inflation, which masks the distinction between supply and demand shocks,” said Beckworth, who is a professor at Western Kentucky University.
He advocates targeting price levels since they move “inversely with productivity-driven changes in real GDP.” Targeting the growth of total dollar spending “allows supply shocks to be reflected in relative price changes rather than falsely triggering action by the central bank when inflation changes,” Beckworth said.
This shift to targeting price levels instead of inflation rates is one supported by Minneapolis Federal Reserve Bank President Narayana Kocherlakota in May and brought up again this week in a speech in Minnesota.
“If the FOMC were to decide today to follow price level targeting, then businesses would anticipate more stimulative future monetary policy and, consequently, higher future demand,” Kocherlakota said Tuesday.
“That expectation of higher demand would provide an additional incentive for them to hire and invest today,” he said, making the case that a decision to adopt price level targeting would be an automatic stabilizer to the economy.
Kocherlakota, who does not see the Fed returning to its 2% target until 2018, says targeting prices instead of inflation would allow the Fed to overshoot to make up for time spent below the 2% target.
He stressed that he has not made up his mind definitively in favor of price targeting, but said it “should be a subject for serious discussion among central bankers.”
There does not seem to be a lot of interest in shifting policy targets at the moment from the Fed, and any effort to make the change is likely to run into opposition.
St. Louis Fed’s James Bullard said in a late-2012 speech that the “the FOMC has in fact essentially behaved as if it was price level targeting.” In this sense, inflation targeting policy since 2008 “looks close to optimal,” he said, calling this “a singular achievement of recent monetary policy.”
But Beckworth makes the case in his research that a lot of success in inflation targeting “was dependent on stable and benign economic conditions.” And as the global economy becomes more financially developed and integrated, “the shortcomings of inflation targeting will likely only grow.”
Inflation targeting fails, he argues, when there is a “positive supply shock, such as a cost-reducing technological innovation that increases productivity, can lead to falling prices.”
This could be viewed as too-low inflation and cause a central bank to ease monetary policy, he said. “Doing so, however, would add excessive monetary stimulus to the technology-driven economic gains and create an unsustainable bubble.”
A negative supply shock, such as a decrease in the supply of oil, could cause an increase in prices overall and lead to higher inflation, he writes.
“This would require an inflation-targeting central bank to tighten monetary policy,” he said, adding that it would constrain economic activity and inflict more harm on an economy already grappling with the effects of higher commodity prices.
Beckworth also points out that inflation targeting does not promote financial stability. To counter deflationary pressures from productivity gains, central banks will ease policy to achieve the inflation target, he said.
“Easy monetary policy pushes short-term interest rates below the stable, market-clearing level, incentivizing households and firms to take on more debt,” he said. “The result is unwarranted capital accumulation, too much leverage, soaring asset prices, and ultimately a buildup of financial imbalances. Such booms from easy monetary policy can turn into economic busts.”
Targeting the growth of total dollar spending would make the Federal Reserve’s monetary policy “much more predictable,” he said.