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That is a very interesting post. Can you imagine the political uproar though if the Bernanke Fed announced that it wanted to see the US price level 5-10% higher in the next 2-3 years? (side questions - which price level? would housing be included in the price index chosen? does this qualify as asset price targeting?)

Thanks Brendon! I'm not really a Fed-watcher, but I think the Fed has made a number of statements about trying to keep inflation around 2%, though without a formal commitment, so a path for the price level growing at 2% should not be too revolutionary. The hardest part would be trying to explain to the math-challenged the difference between a 2% inflation target and a 2% price level path! And given the very revolutionary changes to the Fed's balance sheet, I don't think it would raise eyebrows in comparison.

Which price index? Dunno. I think it should probably be a broader price index, including some asset prices. But that might make it harder to communicate. Because asset prices are more flexible, and the data on many asset prices (not houses) is available more quickly, and because it is the level of real asset prices (as well as the rate of change of nominal asset prices) which affects AD, I think price-level path targeting is even more appropriate when asset prices are included in the index.

But my head's not clear on the interrelationship between the two questions: narrow vs. wide price index; price level vs. inflation targeting.

Nick: wouldn't this also serve to reduce a lot of the perceived inflation risk from long term nominal interest rate bonds? It might offer some comfort to people retiring that there is a target price level for 10, 15, 20 years out.

I guess my thinking was specific to the current US housing situation - if the Fed announced a broad price level target that included a significant weight on housing it might stem the decline in the market -though somewhat artificially since inventories are still too high.

Andrew: yes, the main argument for price level vs inflation targeting is that the price level becomes much more predictable at long horizons. Under inflation targeting, the price level follows a random walk (with drift), so the forecast variance goes to infinity in the limit.

Brendon: I'm not sure if we would want to influence the real price of houses, provided we don't need to do so to get out of the liquidity trap.

I expect my main motive for writing the post was frustration with all the focus on fiscal policy, plus quantitative and qualitative easing with current monetary policy, with no focus on what might be the most effective way to stimulate demand -- directly anchoring expectations of future price levels.

Nick: There is a lot of concern that recent global monetary measures may have been too lax (a Greenspanesque policy response on a global scale)and some fear inflation down the road. Personally, I can't help but wonder if this concern could be used to the central banker's advantage. Especially in situations where inflationary expectations are sticky around where the central bank says inflation will be.

This is what I have in mind. Purely hypothetically, if (say) there were problems lowering the nominal rate below 0.5% (below that some capital markets may not function well if there are transactions costs), and (say) the real rate of interest required to close the output gap (at this juncture) was -3%, then inflationary expectations need to be at least 2.5% to do the job. I wonder whether a credible inflation targeting central bank should consider announcing that it would tolerate inflation at the upper end of its target band (say 3%) while interest rates are at 0.5% as long as it takes to close the output gap and for real rates to normalise. Such a conditional announcement would essentially provide the same outcome as a switch to price level targeting but without a formal switch in the policy rule. The problem is that such a policy may be seen to erode the credibility of the central bank. What do you think?

Hume: a conditional inflation targeting policy like you describe, if it were made symmetric (so it works in reverse if inflation gets too high) would be very similar to price level targeting, but might be harder to communicate. In the US, where they don't have a formal target (but I'm hearing more talk in the last few days of them adopting one) they might as well go to a price level target right away. In Canada, your proposal would make more sense, since it's sort of finessing the existing inflation target, and still keeping within the 1% to 3% target range. Or they could just wait until the inflation target comes up for renewal, since the problem doesn't (yet) seem quite as urgent here as in the US. Dunno.

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