From Bullard´s October 4 presentation:
The U.S. economy experienced a large shock in 2008-2009.
1. Imagine monetary policy reacted in just the right way to the large shock.
2 What should have happened?
1. The FOMC should have maintained the price level on the established path.
2. So-called “price level targeting” can be the optimal monetary policy according to some leading theories.
A singular achievement
The FOMC has in fact essentially behaved as if it was price level targeting.
In this sense, policy since 2008 looks close to optimal.
This is true even though the Committee did not explicitly say that maintaining the price level path was an ultimate goal.
Instead, the Committee simply kept inflation close to a value of 2 percent even in the face of the large shock.
The actual price level in the U.S.
One issue in thinking about the U.S. price level is the choice of a starting date.
During the mid-1990s, the FOMC began to establish inflation rates of around 2 percent as the norm in the U.S.
During the 1970s, 1980s, and early 1990s, inflation was higher than 2 percent.
Let’s take the 1995 price level and project a 2 percent inflation price level path from that point forward.
Is the actual U.S. price level close to this path? Yes, it is.
And puts up this chart:
According to Bullard:
The behavior of the aggregate price level might be viewed as a “signature” of optimal monetary policy in this simple framework.
In his summary he states:
Simple versions of a leading macroeconomic theory suggest that the price level path can provide a “signature” for optimal monetary policy.
The U.S. experience seems to satisfy this signature test, because the actual aggregate price level in the U.S. is quite close to the path established beginning in the mid-1990s.
What if the Big Shock Bullard refers to was brought on by the perception that the Fed would constrain future nominal spending to bring the price level back to trend following the rise observed in the PCE due to the oil price increase of 2007-08? The evidence for this conjecture is right there in the FOMC statements and minutes of late 2007 and all the way to the September 2008 meeting. As late as the June 2008 meeting we read from the minutes:
Members commented that the continued strong increases in energy and other commodity prices would prompt a difficult adjustment process involving both lower growth and higher rates of inflation in the near term. Members were also concerned about the heightened potential in current circumstances for an upward drift in long-run inflation expectations. With increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting.
If as argued by Bullard the Fed was implicitly targeting the PCE price index it would be concerned with the rise in the index above the target path and would have to react to the effects of the oil shock.
But to have monetary policy react to real or supply shocks is destabilizing. Therefore, a bad move.
Bernanke is the “slave” of two obsessions. One is his obsession with the impairement of credit flows. He thinks that´s exactly what made the Great Depression “Great”. His classic 1983 paper on “Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression” leaves no doubt about it:
His other obsession is inflation targeting. Long before becoming a Fed Governor he argued that the Fed should explicitly target inflation. In “What happens when Greenspan is gone?” we read:
We think the best bet lies in a framework known as inflation targeting, which has been employed with great success in recent years by most of the world’s biggest economies, except for Japan. Inflation targeting is a monetary-policy framework that commits the central bank to a forward-looking pursuit of low inflation—the source of the Fed’s current great performance—but also promotes a more open and accountable policy-making process. More transparency and accountability would help keep the Fed on track, and a more open Fed would be good for financial markets and more consistent with our democratic political system.
To protect the financial system, under strain from the mortgage debacle following the drop in house prices, as of late 2007 the FOMC devised special liquidity provision programs – things like TAF, TSLF, Swap Lines with foreign central banks, among several other. That would allow a separation, leaving monetary policy free to deal with the risk of ballooning inflation.
Even if you choose to do price level targeting, a price level that is sensitive to certain price shocks – like oil and commodities – is not the best choice. Let´s see what was happening to the core version (which excludes food and energy) of the PCE, under the same criteria Bullard uses to devise the PCE level trend.
One can see that the information provided is very different. In fact, through most of the time the PCE-C price level has remained below the 2% inflation trend path from 1995, and would not be a matter of concern for the FOMC in 2008. And it still remains significantly below the trend path.
Yes, some will say: “my budget includes food and gas”, so the core “distorts” the inflation I really experience. No doubt it does, but the objective of monetary policy should be to provide confidence that over time prices will evolve in a stable and predictable fashion.
Let´s take stock.
The next chart shows both PCE and PCE-C price levels over more than 50 years. They both begin and end at the same level. In other words, over time they give out exactly the same information of the “Price Level”. So, why should it be “bad” to target the PCE price level instead of the PCE-C price level.
That´s because the PCE is much more “noisy”. This is observed in the following chart depicting PCE and PCE-C inflation over the same period.
Note that in the late 1960s and 1970s, both inflation indicators trend up. That´s the classic definition of inflation – a continued increase in all prices. Relative price changes continue to take place – see, for example, that at the time of the oil shocks PCE inflation is higher than PCE-Core inflation. The 1980s and early 1990s was a period of disinflation. And relative price changes also happen – see 1986 when oil price tanked when Saudi Arabia “broke” the cartel.
While during the “Great Inflation” all price changes were trending up and during the disinflation period all price changes were trending down, during the period of stable (2%) inflation, the PCE inflation reflecting changes in relative prices that go on all the time, is much more variable, volatile or “noisy” than PCE-Core inflation. That certainly makes monetary policy which targets either PCE inflation or the PCE price level much harder to enact or even follow.
But it isn´t only Bullard that is wrong in proposing that the Fed target the PCE price level. In January of this year Bernanke saw his “dream” come true and established an explicit PCE inflation target (which is even worse than targeting the PCE price level):
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.
In the same FOMC release we read:
The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision.
And during the discussions after his presentation, Bullard said (referring to discussions that took place in the Sept. 13 FOMC meeting):
“I think we should be very cautious about tying monetary policy explicitly to the unemployment rate,” he told reporters on the sidelines of the dinner event, warning that the Fed could find itself in a policy “box” with such an approach.
On that point he´s perfectly correct.