In my previous postI have expressed concern that the Fed may be planning to move policy even further away from a “level targeting” approach. One criticism of symmetric level targeting is that it could be politically unpopular to cut prices at a time when inflation has exceeded the central bank’s target path. A recent article in the Financial times suggests that exactly the opposite may be true:
Many major central banks have implicitly returned to setting monetary policy based on Taylor Rule models, with interest rates anchored around the extent to which the economy is away from the inflation target, and the degree of slack in the economy. However, these elections indicate that voters prefer more price stability over low inflation rates or full employment.
If so, central banks may want to review an alternative policy framework; the idea of price level targeting, as proposed by Professor Michael Woodford of Columbia University. In this framework, policy aims for a constant increase in the price level over time, so that if prices rise above that level, the policy should respond sufficiently to reverse any price differences. This is in stark contrast to the current framework, which can celebrate a return to 2 percent inflation even if the target has not been met for several years, and which has caused households to suffer large losses in real purchasing power. By encouraging early action to limit the initial deviation from desired price levels, this framework could theoretically benefit consumers.
We must be careful when interpreting the election results. If we saw a return to high unemployment, voters might become more concerned about unemployment than high prices. But I don’t see any compromise here. A policy targeting the NGDP level, or even a true “flexible average inflation” policy (not the Fed’s policy) would produce both more stable prices and more stable employment in the long run. Ultimately, it is economic success that is politically popular.