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Economy in Brief

Seven Sins of Price-Targeting
by Joseph G. Carson ([email protected])  May 28, 2019

Policymakers are conducting a review of its monetary policy framework, with the 2% inflation target under scrutiny. I have identified seven sins (flaws or misleading claims) about the Fed's price targeting framework that they might want to look at before contemplating making changes to existing policies and practices.

First---the selection of a price index. Policymakers selected a consumer price measure to be its preferred price index. The problem with this selection is that consumer price measures no longer capture the price signal from the owner's housing market, one of the more important cyclical inflation signals. The fact that consumer price measures failed to capture the 2000s house price speculative bubble, one of the largest house price cycles in decades, should disqualify the consumer price index or the personal consumption deflator from being used as a general price gauge for monetary policy. A broader price index is needed.

Second---point estimate for price stability. Policymakers have defined price stability as a 2% increase in consumer prices. Selecting a point estimate for price stability implies a precision in price measurement and monetary policy that does not exist in practice. Inflation moves up and down and many times these changes are unrelated to the economy's strength or weakness or the stance of monetary policy. It would be better to use a wide target range for inflation, similar to the old rules on money and credit, as the relationship between growth and inflation is not an exact science.

Third---price stability and maximum growth. Policymakers argue that "price stability" is the best way to achieve maximum growth. Yet, the Fed has offered no empirical research that proves unequivocally 2% is the optimal inflation rate for the US economy, or that there are economic costs at higher inflation rates. Even former Fed Chair Mr. Bernanke, the person behind the 2% rule, stated, "I don't see anything magical about targeting 2% inflation".

Fourth---price stability anchors inflation expectations. Policymakers place a lot of emphasis on inflation expectations and yet they are unsure how people's inflation expectations are formed. Former Federal Reserve Chairman Alan Greenspan argued that price stability is an environment in which households and businesses do not factor inflation expectations into their investment decisions. As such, the price-targeting framework maybe focused on the wrong set of inflation expectations. Nowadays, two areas where inflation expectations matter a lot are real estate and financial markets (equity investments) and both are excluded from the Fed's price-targeting framework.

Fifth---price stability ensures financial stability. Policymakers see no conflict between price targeting and the preservation of financial stability and yet in practice there does appear to be one. Policymakers always talk about "macro-prudential" supervision to prevent financial excess from creating financial instability, but they fail to acknowledge that low interest rates can be a source of financial instability. Today, the price/sales ratio of the S&P 500 is 2X, matching the high levels of the tech equity bubble years, and that the ratio of total liabilities to gross revenue for nonfinancial corporations is at a record high suggesting that the pursuit of price stability via low official rates may be creating financial excesses that triggered financial instability in the past.

Sixth---price stability lessens recession risks. Except for the 1970s when consumer price inflation hit double-digits, there does not appear any correlation between the length of the expansion and frequency of recession with inflation rates. The expansions of the 1960s and the 1980s lasted 106 and 92 months respectively and both ended with consumer price inflation slightly above 5%. The expansions of the 1990s and 2000s lasted 120 and 73 months respectively and ended with consumer price inflation around 2.5%.

Seventh---price targeting as a communication tool. Price targeting was seen as a way for policymakers to broaden their communication tools. But better communication only works if policymakers "words" match people's experiences. Kansas City Fed President Ester George recently stated, "As I listen to business and community leaders around my region, I hear few complaints about inflation being too low. In fact, I am more likely to hear disbelief when I mention that inflation is as low as measured in a number of key sectors. This leads me to the observation that inflation experience by households and businesses is fundamentally different from inflation as viewed by financial markets and many economists."

An effective price-targeting framework requires a representative price sample, matching people's experiences, and one that offers flexibility so not to straightjacket the economy or policymakers. The current framework fails.

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