Inflation Targeting vs Price Level Targeting

RGE Monitor

Overview

In a July 16, 2009, report, Morgan Stanley (MS) asserts that the pre-crisis period showed that "stabilizing consumer price inflation does not automatically stabilize asset prices. On the contrary." Moreover, the OECD notes that several nations have hit the zero bound of nominal interest rates, which highlights the shortcomings of the low-inflation-targeting framework. Among the possible options to reduce the downside risks of deflation are increasing inflation targets and "target[ing] a price level path instead of an inflation rate because a credible price-level targeting regime can practically eliminate the risk that policy rates may be constrained by the zero floor" (June 24, 2009).

Too Much Debt and Leverage
* Anja Hochberg, Credit Suisse: "The carefree granting of credit to consumers and the interest in securitized loans on the investor side were phenomena that could only have occurred under specific conditions: a long period of historically low interest rates." (August 18, 2009)
* Daniel Gros, Stefano Micossi, Jacopo Carmassi (Vox-EU): "Without lax money and excessive leverage, reckless bets on asset price increases would have been much reduced. A repeat of this instability could be avoided in the future by correcting those two policy faults. By and large, there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments." (August 13, 2009)
* Jan Schildbach (Deustsche Bank): "Banks' net interest income has been boosted for the past 30 years by a structural decline in interest rates that fueled an exceptional lending boom. Falling interest rates are beneficial for banks as the pass-through of interest rate changes differs on the asset and liability side of the balance sheet."
* Hyun Song Shin, Tobias Adrian (Princeton U./NY Fed): "Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries. We document evidence that marked-to-market leverage is strongly procyclical as financial institutions seem to target a fixed leverage ratio throughout the cycle."
* Nassim Nicholas Taleb and Mark Spitznagel, Universa Investments: "The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to GDP that we had in the 1980s. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option." (FT; July 13, 2009)
* Keiichiro Kobayashi: "The existing theoretical structure of macroeconomics is incapable of addressing macroeconomic performance and the stability of the financial system in an integrated context." The author proposes a paradigm shift. See also Luigi Spaventa, CEPR, reaching similar conclusions.
* see also the evolving Tobin Tax debate set in motion by the FSA's Adair Turner.

Higher Inflation Target?
* Thomas Palley, Director of the Globalization Reform Project, Open Society Institute: Financial innovation and deregulation increase the elasticity of private money creation. The optimal monetary policy and financial stability framework in this setting includes two components. One is an inflation target at the Minimum Unemployment Rate of Inflation (MURI), somewhere between 2% and 5% instead of an a priori "low" level based on the Non-Accelerating Inflation Rate of Unemployment (NAIRU) framework. The second are countercyclical, asset-based reserve requirements that prevent the build-up of credit overextension in the first place (off-balance-sheet items need to be taken into account.) Both MURI and NAIRU are unobservable, but the MURI concept errs on the side of steering clear of deflation traps in the face of easy debt creation, whereas the NAIRU concept errs on the side of structural unemployment and a permanent demand deficit trap--the flip-side of "awash with liquidity" (see the July 19, 2009, Joseph Stiglitz lecture). See Liquidity Trap Revisited.
* Stephen Cecchetti, BIS Chief Economist: Adding "leaning against the wind" and macro-prudential systemic risk provisions in monetary policy "does not mean forsaking central banks’ price stability objectives, as it is not aimed at changing long-term targets or goals." (July 17, 2009) See Systemic Risk Supervision around the World

Price Level Targeting
* FT: "Under a price-level target regime, rather than aiming for an annual inflation rate of 2%, for example, a central bank would target a CPI index of 100 in the first year, 102 in the second year, 104 in the third and so on. While inflation targeting is forward looking and does not attempt to correct for past undershoots or overshoots, a price-level target takes into account past performance–so if the central bank overshoots its target one year it will aim to undershoot in subsequent years in order to bring the price index back on track, and vice versa." (August 26, 2009)
* Joachim Fels & Spyros Andreopoulos, MS: "The major advantage of PT is that, if credible, long-term inflation expectations are actually more stable than under IT. During the Gold Standard, which implicitly was a price level-targeting regime, the long-run price level was given by the quantity of gold in the international monetary system. Periods of inflation were followed by periods of deflation because there was a built-in automatic stabilizer, and the price level was stable over the long term." (July 16, 2009)
* see Will Inflation Targeting Give Way to Price Level Targeting?

Aug 29, 2009
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