The Daily Update - Rethinking Price Stability-Part II

Over the next few days, we feature extracts from our macro-economist Bob Gay’s latest piece ‘Rethinking Price Stability’

Part II: Options for a New Target:

Three possible options are 1) raising the inflation target to say 3%; 2) targeting an average inflation rate of 2% over an extended period of time; 3) targeting a price level consistent with steady state inflation rate of 2%. There may be other frameworks under consideration, but they probably will fall within these three general categories. To me, raising the inflation target (#1 above) seems arbitrary and lacking in a straightforward and defensible rationale like that of the 2% target. Similarly, changing to some average inflation rate formula (#2 above) is not worth the trouble, as it requires a justification for the time period chosen and as such lacks transparency. Besides, the Fed already can achieve the same result with the current target by allowing some overshooting as the Board has often said they would.

That leaves a target level of one or more price indexes as a possibility. Such a methodology would parallel how the staff thinks of full employment – namely, as the level of GDP consistent with its long-run potential. An ‘inflation gap’ – the difference between the actual level a price index and its long-term level consistent with steady 2% increases – would be akin to the ‘output gap’ that is used in their empirical models for inflation. The trouble here, though, is that the output gap is not simple to understand and neither will an inflation gap. Combining these two concepts in effect would amount setting a target for nominal GDP, which has been suggested by some advocates of change. The shortcoming of using this single target, in my opinion, is that this approach obscures the inherent tradeoff between growth and inflation once the economy approaches full employment.

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