Tuesday, October 19, 2010

Coming soon: price-level targeting

FOMC minutes 10/21:
Many members considered the recent and anticipated progress toward meeting the Committee's mandate of maximum employment and price stability to be unsatisfactory...

Several members noted that unless the pace of economic recovery strengthened or underlying inflation moved back toward a level consistent with the Committee's mandate, they would consider it appropriate to take action soon.

With respect to the statement to be released following the meeting, members agreed that it was appropriate to adjust the statement to make it clear that underlying inflation had been running below levels that the Committee judged to be consistent with its mandate for maximum employment and price stability, in part to help anchor inflation expectations. Members generally thought that the statement should note that the Committee was prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

It’s not about QE.

The media is abuzz with discussion of QE2. The Fed is going to buy more bonds in the hope that deflation will be avoided.  

The FOMC is not discussing buying more bonds. They’ve already done that. They are discussing the fact that they have failed to meet their informal inflation target by 50% (1% vs 2%) and their full employment target by 50% (10% vs 5%). They are beginning to confront the fact that, by any objective measure, they have failed (just as the BoJ has failed and as the ECB will fail).

So instead of talking about how much more bonds to buy, they are finally talking about targeting outcomes instead of policy inputs. Their intended outcomes (more or less enshrined in law), are moderate inflation and full employment.

Once the discussion shifts from policy inputs (“Should we buy another $500 billion?”) to outcomes (“What are we targeting?”), everything changes, and quite dramatically.

The FOMC has four possible targets, listed in increasing degrees of radicalism:
1. Inflation (change in the CPI)
2. Price level (the CPI itself)
3. NGDP growth (change in NGDP)
4. NGDP level (NGDP itself)

Bernanke advocated #4 in Japan in 2002. But, tragically, it’s way too radical for the country club regional bankers on the FOMC. But the Chairman seems to be on the verge of building a consensus in favor of #2, targeting not change in the CPI, but the CPI level itself.

What does this mean? It means (assuming that Bernanke prevails) that the Fed will do whatever it takes to achieve its targeted price level. So if the CPI is 123 today and the target is 126, the Fed will expand the money supply until the target is achieved, even if this means a massive expansion of its balance sheet. It also means that if they undershoot, they must catch up with above-normal inflation.

There is no limit to the tools used, only to the goal meant to be achieved. This is what is so scary for the members. What if it takes $7 trillion?  $17 trillion? What if they overshoot and inflation breaks out? Isn’t it easier to just buy another trillion of treasuries and see what happens?

The problem with QE (as the Japanese have learned) is that it doesn’t create inflationary expectations, and thus productive-sector behavior doesn’t change.

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