MS: From Inflation Targeting to Price Level Targeting?

Morgan Stanley - Global Economic Forum

Global
From Inflation Targeting to Price Level Targeting?
July 16, 2009

By Joachim Fels & Spyros Andreopoulos | London

Tougher times for inflation targeters: Over the past two decades, inflation targeting has become the holy grail of modern central banking. Most central banks have adopted some form of inflation target and have set interest rates mainly with a view to stabilising inflation around that target over the medium term. However, the recent experience poses a major challenge for inflation-targeting central banks, for two reasons:

• First, the wild gyrations of commodity prices and the boom-bust credit and economic cycle have caused big swings in inflation. Only a year ago, actual inflation was way above most central banks' targets; now it is far below in most cases. This has contributed to rising uncertainty about the longer-term inflation outlook, as illustrated by more volatile market-implied inflation expectations and by a much greater dispersion of economists' inflation forecasts.

• Second, the asset price bubble and bust has been a useful reminder that stabilising consumer price inflation does not automatically stabilise asset prices. On the contrary, as we have argued repeatedly over the years, by focusing too narrowly on consumer prices, which were kept low for a long time by non-monetary factors such as globalisation, deregulation and IT-led productivity increases, central banks fostered asset price inflation by keeping interest rates too low for too long. Looking ahead, many central banks are thus likely to pay more attention to asset prices in setting monetary policy. This, in turn, may lead to bigger and longer-lasting deviations of inflation from target and thus constitutes a challenge to the credibility of their inflation targets (see "The Morning After", The Global Monetary Analyst, April 1, 2009).

Move to price level targeting would make sense to us: Despite its shortcomings, it would be risky to abandon inflation targeting altogether. A better solution, in our view, would be to modify the existing approach and move from inflation targeting (IT) to price level targeting (PT). Under price level targeting, the central bank aims at a certain path for the price level, with the rate of increase in the price level given by the inflation target. So what's the difference, and why does it matter?

Introducing ‘memory' into inflation targeting: In the case of IT, there are no consequences if the central bank misses its inflation target in one period. Past errors will not be corrected but, at each point in time, the central bank will set the policy rate such that the inflation target is achieved over the next period. Thus, inflation outcomes above or below the average would simply be followed by average inflation. As a result, the price level drifts away from the level implied by the inflation target over time.

With PT, on the other hand, past deviations from the price level target would have to be compensated for in the future in order to return to achieve the target in the medium term. Above-average inflation in one period would have to be followed by below-average inflation in the following period(s).

So PT is like pursuing an inflation target over a longer time horizon, which is why PT is sometimes called ‘average inflation targeting'. And that is how PT could be explained to the public. The central bank's aim would now be to hit the inflation target ‘on average' over a series of years. Overshoots would have to followed by undershoots and vice versa.

PT would help to stabilise long-term inflation expectations: 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 stabiliser, and the price level was stable over the long term. And PT would, if pursued consistently, enhance central bank credibility: monetary policymakers would now be more immediately accountable for past errors - they would have to respond to them directly. Greater accountability would, in turn, increase credibility.

Academic? We think that at the current juncture, this advantage of PT would be particularly useful for central banks, for three reasons:

• Central banks may in future want to - at least occasionally - lean against the wind with respect to asset prices, following the experience with the credit and house price boom-bust. This would probably imply larger and/or longer deviations from the inflation target (see our piece from April 1, 2009, cited above). PT would allow monetary authorities greater flexibility in occasionally responding to asset prices without unanchoring inflation expectations, because they would have committed themselves to correcting deviations from the target at a later stage.

• PT is more helpful at the zero lower bound for interest rates. Under IT, when actual inflation falls below target or even becomes negative, inflation expectations would also fall. But lower inflation expectations would increase real interest rates, while the economy may need stimulus through lower real interest rates. With PT, on the other hand, near-to medium-term inflation expectations would automatically increase, since the public would expect the undershoot in inflation now to be compensated by a later overshoot. Hence inflation expectations act as an automatic stabiliser under PT. (See, for example, Riksbank Deputy Governor Svensson's speech: Monetary Policy with a Zero Interest Rate.)

• PT would also be helpful over the next few years, if inflation were to rise above target but central banks were reluctant to raise interest rates because of fragility in the financial sector or the real economy. With PT, an overshoot of inflation over the target would, rather than being an embarrassment for central banks, be a desired (indeed necessary) correction for the undershoots of the recent past. We looked at the path for the US price level (measured by headline CPI and PCE, respectively) starting from September 2008, the peak of the financial crisis. In the short and medium term (using our US team's forecasts out to 4Q10), the price level is below the level implied by a 2% PCE inflation target. In order to catch up from the 4Q10 level to the level implied by the inflation target by 4Q12, a 3.6% average annual inflation rate between 4Q10 and 4Q12 would be required. Thus, any overshoot would merely be a return to the medium term target level.

Having one's cake and eating IT: To summarise, adoption of PT would potentially allow central banks to deviate from their inflation targets without putting their credibility at stake: they could have their cake and eat it.

Not a popular concept...yet: With so many advantages of PT over IT, why hasn't it been adopted widely already? In fact, there are very few examples of central banks adopting PT or something resembling it. The only country that adopted an explicit price level target was Sweden from 1931 to 1937 (see C. Berg, L. Jonung, "Pioneering Price Level Targeting: The Swedish Experience 1931 - 1937", Journal of Monetary Economics, Vol 43, 1999). Today, the Reserve Bank of Australia probably comes closest to a (somewhat vague) price level target by stipulating that it aims to keep inflation at 2-3% "on average over the cycle". Probably the main reason why PT hasn't been adopted more widely is that a central bank that is targeting a path for the price level would spend approximately half of its time trying to deflate or disinflate the economy. It is easier to let bygones be bygones and start from scratch each period. But here's the catch: with inflation now having fallen significantly below target in many countries, by adopting a price level target with a starting point in, say, the middle of last year, central banks could spend the next few year inflating their economies and sell this as being part and parcel of a credible price level-targeting strategy. Given the fragile state of the global economy and the financial system, this prospect may look quite appealing to some. Stay tuned.

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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
Associated Readings (18 Articles)

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Triple time-inconsistent policies

Triple time-inconsistent policies: "Guillermo Calvo, 31 August 2009

This column introduces 'triple time-inconsistent' episodes. First, a public institution is expected to cave in and offer a bailout to prevent a crisis. Then, in an attempt to regain credibility, it pulls back. Finally, it resumes bailing out the survivors of the wreckage caused by the policy surprise. This column characterises the 1998 Russian crisis and the current crisis as triple time-inconsistency episodes and says that a financial crisis may simply be a bad time to try to build credibility.

Full Article: Triple time-inconsistent policies"

Fear of appreciation in emerging economies

Fear of appreciation in emerging economies: "Andrea Kiguel, Eduardo Levy-Yeyati, 29 August 2009

After a crisis-induced hiatus, the exchange rate landscape seems to be moving back to a situation that resembles 2007. This column says that fear of appreciation is part of a leaning-against-the-wind exchange rate policy that promises to be the norm for emerging economy currencies for years to come. That may pose difficulties for global rebalancing.

Full Article: Fear of appreciation in emerging economies"

Westfield Results Demonstrate Decline In U.S. Mall Market

Westfield Results Demonstrate Decline In U.S. Mall Market: "

Westfield, the world's largest mall operator, announced results earlier today, which demonstrated substantially accelerating real estate writedowns, primarily in the US. For the six month period ended June 30, Westfield announced $2.5 billion in property revaluations, after posting $2.6 billion in comparable charges for the entire 2008 year period: the company is finally marking its asset book to something vaguely resembling reality. 

As a result of deteriorating operations, the company also announced it would reduce its dividend payout from 100% of earnings to 75%, in anticipation of a liquidity crunch resulting from over $19 billion in debt maturing between 2010 and 2014.

Other notable data: U.S. retail sales on a per square foot basis declined by 6.2% from $437 to $410 just over the past six months, and by 10.8% from June 2008: the worst deterioration of any of the company's regional properties.

Furthermore, cap rates have increased by over 0.3% across Westfield's four regions over the last 6 months, with the U.S. surprisingly representing the highest end range.

Also, notably the weakest retail categories were jewelry, fashion and leisure, all of which declined by over 10% year over year.

Net-net: the news that the deterioration in the U.S. mall market shows no indication of abating, and rent capacity is substantially deteriorating, not only for the company's 8,889 US malls, but for bankrupt GGP and its competitors, will likely be sufficient reason for other garbage REITs with deteriorating performance metrics to see their stocks jump once again for no other reason aside from... well, no other reason, which seems to be same principle that drives stock trading each and every day in all other garbage sectors.

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NY Fed Launches Interactive Maps Of Economic Collapse

NY Fed Launches Interactive Maps Of Economic Collapse: "

The kind folks at the New York Fed have launched a useful service whereby citizens can look at the collapse of the credit economy in real, interactive time as they buy Fannie, Freddie and Citi stock (which at last check had a pro forma market cap higher than Bank of America).

The link for the maps can be found here in case anyone needs ongoing confirmation of the prevlance of red shoots.

At first glance, it seems that delinquent auto loans is where much more red is still due, while the bloodletting in mortgages has reached quite epic proportions and shows no sign of abating.

The charts below demonstrate the year over year deterioration across four key credit verticals:

Auto Loan Delinquency Rate 60 + Days:

Bank Card Delinquency Rate 60 + Days:

Mortgage Delinquency Rate 90 + Days:

Student Loan Delinquency Rate 90 + Days:

For the full interactive charts, don't be shy and check out the Fed's website.

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No way out

Federal Reserve Has No Strategy to Unwind Easy Monetary Policy - WSJ.com

We're beginning to wonder if the Ben Bernanke Federal Reserve isn't populated with French existentialists. A la Jean-Paul Sartre, they have a "no exit" strategy when it comes to unwinding their extraordinarily easy monetary policy. At least they gave no signs of restraint in yesterday's statement after their August Open Market Committee meeting, keeping short-term interest rates close to zero and again promising to maintain current policy for an "extended period."

The Fed is keeping the money pumping even though it also conceded that "economic activity is leveling out," which is an acknowledgment that the recession is all but over. This policy is justified, the FOMC statement said, because the economy still has "substantial resource slack" that will keep cost pressures under countrol "for some time." Unsaid by the Fed, but understood by everyone, is that Mr. Bernanke isn't about to tighten money while he's still auditioning for re-appointment to a second four-year term as Chairman. Fed chiefs who tighten money tend to be unpopular with Wall Street and the political class, though not with the middle class.

The one hint of discipline was the Fed's suggestion that it won't expand its program to buy $300 billion in Treasury debt. The Fed will stretch out its purchases for an additional month into October, but this is probably to reduce the chance of market disruptions when it stops its purchases. The good news here is that the Fed seems to be admitting that this decision to directly monetize the national debt by buying long-end Treasurys was a mistake. It failed to keep rates down and may even have helped increase them as holders of U.S. debt wondered about the Fed's independence from the politicians at Treasury and on Capitol Hill.

Overall, though, the Fed's policy is to keep pressing the money accelerator to the floor. We agree it's hardly time to put the brakes on. But the Fed would be wiser to at least begin slowing to, say, 160 miles per hour from its present Indy car speed of 200 mph. It's a lot safer to slow down gradually than have to screech to a halt to avoid another asset bubble.

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