Evan Soltas
Jun 19, 2012

Doing Its Level Best?

The Fed targets inflation, aiming for a 2 percent year-over-year change in the Personal Consumption Expenditures (PCE) price index, to be precise. It is intended as a "flexible" inflation target -- that is, one which helps accommodate swings in real variables, especially real output and employment -- although in current practice the flexibility is rather lacking.

Yet, for several reasons, the Fed's statement of its legally-prescribed dual mandate does not make a lot of sense.

First, it is inconsistent with its definition in the Humphrey-Hawkins Act of 1977:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.
Humphrey-Hawkins, which establishes the mandate, speaks about levels. Not rates, as is inflation. But levels.

"Stable prices" means, most literally, the price level. One has to take some liberties with the Act to arrive at the conclusion that rate targeting, rather than level targeting, is in the Fed's mandate. Notice that "maximum employment" is also a level; the equivalent rate would be the annual change in nonfarm payroll employment, or something to that effect.

Second, the Fed is trying to combine a rate target of one variable, PCE inflation, with a level target of another, the unemployment rate. The combination introduces a significant lack of clarity, not only in the long- and short-term relationships established in the Phillips Curve, but also because the level variable is dependent upon history (unemployment) and the rate variable (inflation) is not. Consider this problem in the form of the Mankiw indicator, which combines the two variables to the end of deriving a Taylor-type rule for an interest-rate monetary policy. What does the difference of a rate and a level even mean?

Third, given a mixed rate/level targeting regime, the Fed has what should be the rate and what should be the level backward. In the long run, the Fed has almost no control over the unemployment rate, yet almost total control over the price level; in the short run, it does have some control over real variables such as unemployment. Given those constraints, it makes far more sense to level-target the variable which the Fed controls in the long and short runs, i.e. the price level, and to rate-target the variable over which the Fed has some control in the short run, i.e. change in nonfarm payroll employment or quarterly real output growth.

Fourth, the academic literature views price level targeting as better than inflation targeting. (See here, for one example.) In most respects, a price level target would be the same as an inflation target; the two differ in respect to history. If inflation was higher than the target for a year, the rate-targeting central bank would "forget" it; the level-targeting central bank would have to compensate by undershooting in terms of inflation for the next year. The rate-targeting central bank thus suffers from "base drift," which is economically inefficient in a model economy with contracts spaced out over different lengths of time, because it is the price level, not year-to-year inflation, which determines the purchasing power of nominal wage contracts or the amount repaid on a nominal interest rate loan. Economic calculation is less uncertain when all agents operate without concern as to "base drift" and can expect a stable price level path.