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Thoughts on a Long-Run Monetary Policy Framework, Part 2: The Principle of Bounded Nominal Uncertainty
In yesterday's macroblog post, I discussed one of the central monetary policy questions of the day: Is the possibility of hitting the lower bound on policy rates likely to be an issue for the Fed going forward, do we care, and—if we do—what can we do about it?
The answers to the first questions are, in my opinion, yes and yes. That's the easy part. The last question—what can we do about it?—is the hard part. In the end, this is a question about the framework for conducting monetary policy. The menu of options includes:
- Raising the Federal Open Market Committee's (FOMC) longer-run inflation target;
- Maintaining the current policy framework, including the 2 percent longer-run inflation target, relying on unconventional tools when needed;
- Targeting the growth rate of nominal gross domestic product;
- Adopting an inflation range with flexible inflation targets that are adjusted based on the state of the economy (a relatively recent entry to the list suggested by Boston Fed president Eric Rosengren );
- Price-level targeting.
Chicago Fed president Charles Evans, San Francisco Fed president John Williams, and former Federal Reserve chairman Ben Bernanke, among others, have advocated for some version of the last item on this list of options. I am going to add myself to the list of people sympathetic to a policy framework that has a form of price-level targeting at its center.
I'll explain my sympathies by discussing principles that are central to my thinking.
First, I think the Fed's commitment to the long-run 2 percent inflation objective has served the country well. I recognize that the word “commitment” in that sentence might be more important than the specific 2 percent target value. But credibility and commitment imply objectives that, though not immutable, rarely change—and then only with a clear consensus on a better course. With respect to changing the 2 percent objective as a longer-run goal, my feet are not set in concrete, but they are in pretty thick mud.
Second, former Fed chairman Alan Greenspan offered a well-known definition of what it means for a central bank to succeed on a charge to deliver price stability. Paraphrasing, Chairman Greenspan suggested that the goal of price stability is met when households and business ignore inflation when making key economic decisions that affect their financial futures.
I agree with the Greenspan definition, and I believe that the 2 percent inflation objective has helped us meet that criterion. But I don't think we have met the Greenspan definition of price stability solely because 2 percent is a sufficiently low rate of inflation. I think it is also critical that deviations of prices away from a path implied by an average inflation rate of 2 percent have, in the United States, been relatively small.
Here's how I see it: until recently, the 2 percent inflation objective in the United States has essentially functioned as a price-level target centered on a 2 percent growth path. The orange line in the chart below shows what a price-level path of 2 percent growth would have been over the period from 1995 to 2012. I chose to begin with 1995 because it arguably began the Fed's era of inflation targeting. Why does the chart end in 2012? I'll get to that tomorrow, when I lay out a specific hypothetical plan.
The green line in the chart is the actual path of the price level, as measured by the price index for personal consumption expenditures. The chart explains what I mean when I say the FOMC effectively delivered on a 2 percent price-level target. Over the period depicted in this chart, the price level did not deviate much from the 2 percent path.
I believe the inflation outcome apparent in the chart is highly desirable. Why? Because the resulting price-level path satisfies what I will call the “principle of bounded nominal uncertainty.” In essence, the principle of bounded nominal uncertainty means that if you save a dollar today you can be “reasonably confident” about what the real value of that saving will be in the future.
For example, suppose that in January 1995 you had socked away $1 in cash that you intended to spend exactly five years later. If you believed that the Fed was going to deliver an average annual inflation rate of 2 percent over this period, you'd expect that dollar to be worth about 90 cents in real purchasing power by January 2000. (Recall that cash depreciates at the rate of inflation—I didn't say this was the best way to save!)
In fact, because the price level's realized path over that time hewed very closely to the expected 2 percent growth path, the actual value of the dollar you saved would have been very close to the 90 cents you expected. And this, I think, epitomizes a reasonable definition of price stability. If you and I enter into a contract to exchange a dollar at some future date, we can confidently predict within some range that dollar's purchasing power. Good monetary policy, in my view, will satisfy the principle of bounded nominal uncertainty.
This is the starting point of my thinking about a useful monetary policy framework—and how I think about price-level targeting generally. Tomorrow, I will expand on this thought and offer a specific example of how a price-level target might be put into operation in a way that is both flexible and respectful of the principle of bounded nominal uncertainty.
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