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Clarida on price level targeting

Summary:
David Beckworth directed me to a Richard Clarida speech from a few months back: Five features of the new framework and September FOMC statement define how the Committee will seek to achieve its price-stability mandate over time:1. The Committee expects to delay liftoff from the ELB until PCE (personal consumption expenditures) inflation has risen to 2 percent on an annual basis and other complementary conditions, consistent with achieving this goal on a sustained basis and to be discussed later, are met.42. With inflation having run persistently below 2 percent, the Committee will aim to achieve inflation moderately above 2 percent for some time in the service of having inflation average 2 percent over time and keeping longer-term inflation expectations well anchored at

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David Beckworth directed me to a Richard Clarida speech from a few months back:

Five features of the new framework and September FOMC statement define how the Committee will seek to achieve its price-stability mandate over time:

1. The Committee expects to delay liftoff from the ELB until PCE (personal consumption expenditures) inflation has risen to 2 percent on an annual basis and other complementary conditions, consistent with achieving this goal on a sustained basis and to be discussed later, are met.4
2. With inflation having run persistently below 2 percent, the Committee will aim to achieve inflation moderately above 2 percent for some time in the service of having inflation average 2 percent over time and keeping longer-term inflation expectations well anchored at the 2 percent longer-run goal.5
3. The Committee expects that appropriate monetary policy will remain accommodative for some time after the conditions to commence policy normalization have been met.6
4. Policy will aim over time to return inflation to its longer-run goal, which remains 2 percent, but not below, once the conditions to commence policy normalization have been met.7
5. Inflation that averages 2 percent over time represents an ex ante aspiration of the FOMC, but not a time-inconsistent ex post commitment.8

The first point is defensible, as long as “expects” means expects, but the explanation Clarida provides later is a bit fuzzy on this point:

First element
A policy that delays liftoff from the ELB until a threshold for average inflation has been reached is one element of a TPLT strategy. In our September FOMC statement, we communicated that, along with other complementary conditions, inflation must have risen to 2 percent before we expect to lift off from the ELB. This condition refers to inflation on an annual basis. TPLT with such a one-year memory has been studied using stochastic simulations of the Fed’s FRB/US model by Bernanke, Kiley, and Roberts (2019).

Now “expects” becomes “must have risen to 2 percent before we expect to lift off”. (Note TPLT is temporary PLT, and ELB is the effective lower bound on interest rates, roughly zero.)

So why is this bad? Because I worry that people will focus on the “must”, and not the “expect”.

But haven’t I been saying that central banks need to make firm commitments about monetary policy? Yes I have, but interest rates are not monetary policy; they are a tool of monetary policy. The commitment should be to set the policy tools at whatever level is necessary in order to be expected to reach the policy goal.

After a period of disinflation, the Fed needs to commit to keeping the fed funds target below the natural rate of interest as long as necessary to assure that it expects to achieve the desired make-up inflation. But that does not necessarily mean it must keep the target rate at zero; it depends what is happening to the natural interest rate.

As a practical matter, this may not matter very much in the near term, as inflation is so well anchored that I’m not particularly concerned about an overshoot. But monetary policy should be forward looking and one can imagine scenarios where a low rate commitment becomes highly inflationary.

For instance, in 1949 and 1950 the inflation rate averaged zero. At the time, the Fed was committed to a low interest rate policy. In 1951 inflation shot up to 7.9%. Not surprisingly, in 1951 the Fed reached an agreement with the Treasury Department that ended its commitment to keeping interest rates very low.

I don’t see any 1951 scenarios on the horizon (the Korean War raised the natural interest rate in 1951), but this is why Clarida should emphasize “expects” rather than “must”. I’d prefer a commitment to set rates at a level that insures an average inflation rate of 2%, then let the markets decide what interest rate path will achieve that objective. Better yet, target market forecasts of 4% average NGDP growth.

Point 5 is a bit perplexing, but if Clarida is nodding to the Fed’s dual mandate then it’s acceptable.

For example, the Fed might want to use core inflation as an intermediate target. Because deviations between core and overall inflation are not forecastable ex ante, a policy that is expected to produce 2% core inflation, on average, will also be expected to produce 2% headline inflation, on average. And it’s OK if any core/headline deviations are not trend reverting, as the Fed’s dual mandate suggests that it should also care about unemployment. (Of course in this case they should probably just target core inflation.)

But.and this is very important.any flexibility should be symmetrical. Thus if you allow positive (and permanent) oil price shocks to permanently move the price level a bit higher, then you should allow negative (and permanent) oil price shocks to permanently move the price level a bit lower than the previous trend. Flexibility should not lead to a policy that is expected to produce above 2% headline inflation, on average.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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