Inflation targeting has been the goal of central banks for decades now, either implicitly or explicitly. Of course, they say that they have multiple goals, but they give most attention to the price level. That’s probably because it is easy to measure and more directly related to their activities than the unemployment rate and private financial activity. Price level targeting and inflation targeting are not quite the same thing – but I’m not in favor of either. This post describes what happens when the central bank targets the price level and offsets other changes in the economy in order to achieve their goal.
Volatile Capital Prices
If consumer prices are constant in the face of productivity shocks, then capital prices adjust instead. Capital is just goods that create other goods. If capital becomes more productive, then that means being able to produce more at given prices or being able to produce given quantities at lower costs. The demand for capital is ultimately determined by how profitable it is. This includes the costs of maintenance, the price of output, and the capital’s productivity. All else constant, changes in the revenue produced by the capital for the firm affect the equilibrium price of capital.
If NGDP is constant and capital productivity improves, then output rises and consumer prices would fall. With unit price elasticity of output demanded, the total revenue of the firm remains constant and the nominal capital price does too. The 19th century gold standards had plenty of problems. But one feature was that long-run consumer prices fell and long-run capital prices were more stable.
If, instead, the Fed stokes NGDP to prop up consumer prices, then the firm’s revenue rises. Demand for the capital rises and so does its price. The opposite occurs when there is a negative productivity shock. So, capital price volatility is the trade-off for consumer price level stability if productivity changes. We can argue about which price volatility is better in regard to inequality, investment planning, financial stability, etc. But my strong low-hanging fruit point is that consumer price volatility just pushes the equilibrating mechanism to a different set of prices.
Volatile Income
As I said above, if the Fed wants stable consumer prices, then it must offset the impacts of productivity shocks with changes in aggregate demand – its only lever. Negative productivity shocks are offset with aggregate demand contractions.
People act like they have adaptive expectations. Of course, people differ by how forward-looking they are. So, on average, their expectations are formed by what happened during the prior period or the last time that they observed a similar circumstance. Why does this matter?
Imagine that your income grows at some average rate over the course of years. You spend and borrow with the expectation that your income grows at a relatively stable rate. Then your income unexpectedly contracts as the Fed combats the price impacts of a negative productivity shock. All of your fixed-interest-rate debts are denominated in nominal terms and they don’t adjust when your income falls. So, your income falls unexpectedly and you can’t make your debt payments. You enter deferment, then forbearance, then default, and the lender seizes your assets for auction.
All of this can happen even if an individual’s personal productivity remains constant. If many assets of a similar type are auctioned at once, then those specific prices will be depressed, even if the general price level is not, and lenders will write down losses. The next step is potential insolvency across the financial sector. The Fed’s price level target results in disintermediation as lenders write down losses, people lose assets, and lending becomes prohibitively risky. Without the NGDP contraction, most debts would still be serviced.
Volatile Output
Since consumers have diminishing marginal value and producers face increasing marginal costs, changes in market prices can dampen the impact of shocks on output. If there is a negative productivity shock, then equilibration can occur through a change in price, a change in quantity, or a lesser degree of change in both. Holding prices constant places the onus on the quantity of output transacted to do the equilibrating. At a macro level, this means deeper declines in output and employment in exchange for stable consumer prices.
This mechanism is somewhat abstract and might be easiest to understand with an example. Imagine that all manufacturers of some device face a supply shock such that one of their input prices rises. If manufacturers keep the price of their output stable, then they will find it profitable to produce less. However, if they are able to increase their price some, then the decline in output can be mitigated since a higher price encourages more profitable production than otherwise would occur. It’s not a direct corollary to the macroeconomy, but it’s good enough without delving into the models.
A Rule is Good
Price level targeting is not the worst rule to adopt, but it definitely has problems. It adopts greater instability on other margins in exchange for reducing menu costs and consumer price forecast errors. It’s probably better to have a sub-par rule than to rely on discretionary monetary policy. Even poor rules allow firms and consumers to better plan for the future and to better implicitly anticipate changes in monetary policy. If we could adopt a growing NGDP level target, then that would be better.
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