The US is now an inflation targeter

The WSJ reports:

Federal Reserve Chairman Ben Bernanke on Wednesday got what he’d been seeking for almost two decades: an inflation target.

The Fed said it wants inflation at 2.0% in the long run. The declaration brings it in line with other major central banks, though the Fed remains unique in having an equally important goal of keeping unemployment low, an objective required by Congress.

On Wednesday, he got the target enshrined as part of a broad statement of the Fed’s dual goals, in which the central bank specified that it would use a Commerce Department inflation measure called the price index for personal consumption expenditures to track how it’s doing on inflation. The target is meant to assure the public that the Fed won’t stray on inflation—as it did in the 1970s—and will adjust interest rates to ensure inflation doesn’t go too far above or below the goal.

Bad move! And made worse by the fact that the target is a “headline” index. Let´s take a closer look.

The chart below shows the behavior of the PCE index both “headline” and “core”, where the latter excludes volatile prices like food and energy. Over its history the two indices do not diverge, with the “headline” being sometimes above and sometimes below the “core”.

But as gleaned from the next chart, over shorter periods the difference – and direction – of the changes in the two indices can be significant. So targeting the “headline” is not a good idea. For the last three years, for example, while the “core” PCE inflation has remained well below target, the “headline” PCE has travelled “widely”. Over the 15 years depicted in the chart, average “headline” inflation has been 2.06% and average “core” inflation has been 1.81%. In fact, a major reason for the drastic fall in NGDP after mid 2008 was the Fed´s indication that it was “targeting” headline inflation!

In a period of inflation (a rise in ALL prices) both “headline” and “core” move together, although relative price changes (from a rise in oil prices, for example) still take place. But that´s not the situation pertinent to the US since Volcker successfully contained inflation.

7 thoughts on “The US is now an inflation targeter

  1. I think the “long run” proviso allows them to use “core” PCE inflation.

    It also allows them to ignore other transitory supply side shocks.

    Naturally, I think they need to go to a NGDP growth path rather than have
    a “long run” rule that they ignore in the short run.

  2. I have never understood the sacred status of 2 percent. Why not 3 percent? Why not 4 to 6 percent for recessions? Is targeting 2 percent inflation in a deep recession a path towards Japanitis?

    Should not the target rate of inflation be that which results in highest long-term real growth? What is the economy grows at 5 percent real, with 5 percent inflation for five years? Would that be a “bad” outcome as inflation was “too high”?

    The econo-shamans chant verse about the sacred nature of paper currency. Theo-monetarists say ascetic lifestyles are preferable to anything about zero inflation.

    I prefer prosperity, the material kind. I am a secularist.

  3. Targeting PCE is less stupid that it might sound. Here is my idea: PCE is highly correlated with NGDP. It is basically growing at the rate. Therefore, if you use my method of decomposing demand and supply inflation (Quasi-Real Price Index) on PCE you can actually calculate a index for demand determined the price level. If the Fed targets this price LEVEL it will actually be exactly the same as targeting the NGDP level. Assuming 3% trend growth in RGDP the Fed could target a “demand PCE price level” growth path of 2% – that would be an NGDP growth path of 5%. The Fed of course is targeting the PCE DEFLATOR instead of a Quasi-Real Price Index based on PCE.

  4. Pingback: Let the Fed target a Quasi-Real PCE Price Index (QRPCE) « The Market Monetarist

  5. Pingback: The US is now an inflation targeter – Federal Reserve Chairman Ben Bernanke on Wednesday got what he’d been seeking for almost two decades: an inflation target. « Economics Info

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