I have always said that my blog should be open to debate and I am happy to have guest posts from clever and inlighted economists (and non-economists) about monetary matters. I am therefore delighted that my good friend and colleague Jens Pedersen (I used to be his boss…) has offered to write a reply to “Integral’s” post on price level targeting versus NGDP level targeting. Jens who recently graduated from University of Copenhagen. His master thesis was about Price Level Targeting.
Jens, take it away…
Guest post: Why “Integral” is wrong about Price Level Targeting
by Jens Pedersen
The purpose of this comment is two-fold. First, I argue that ”Integral” in his guest post ”Measuring the stance of monetary policy through NGDP and prices” is wrong when he concludes that the Federal Reserve has done a fine job in achieving price level path stability and by this measure does maintain a tight stance on monetary policy. Second, I present a way of evaluating the Fed’s monetary policy stance based on the theory of optimal monetary policy.
“Integral” assumes that the Federal Reserve has targeted an implicit linear path for the price level since the beginning of the Great Moderation. Following Pedersen (2011) using the deviation in the price level from a linear trend (or the deviation in nominal GDP) to evaluate the stance of monetary policy needs to take into account the potential breaks and shifts in the trend following changes in the monetary policy regime. Changes in the monetary policy committee, changes in the mandate, targets etc. may lead to a shift or break in the targeted trend. Hence, the current implicit targeted trend for the price level (or nominal GDP) should correctly be estimated from February 2006 to take into account the change in president of the FOMC, or alternatively take account of this possible shift or break.
Changing the estimation period changes the conclusions of “Integral’s” analysis. Below, I illustrate the deviation in the log core PCE index from the estimated linear trend over the period 2006:2-2006:12. As the figure show Fed has significantly undershoot its implicit price level target and has not achieved price level path stability during the Great Recession. Currently, the price level gap is around 3% and increasing. Hence, looking at the deviation in the price level from the implicit price level trend does indeed suggest that monetary policy should be eased.
Following, Clarida et. al. (1999), Woodford (2003) and Vestin (2006) optimal monetary policy is a dual mandate which requires the central bank to be concerned with the deviation in output from its efficient level and the deviation in the price level from its targeted level. The first-best way of evaluating Fed’s monetary policy stance should be relative to the optimal solution to monetary policy.
However, this method requires a clear reference to the output gap. Common practice has been to calculate the output gap as the deviation in real output from its HP-filtered trend. This practice is by all means a poor consequence of the RBC view of economic fluctuations. Theoretically it fails to take account of the short run fluctuations in the efficient level of output. Empirically it does a poor job at estimating the potential output near the end points of the sample.
Fortunately, Jordi Galí in Galí (2011) shows how to circumvent these problems and derive a theoretical consistent output gap defined as the deviation in real output from its efficient counterpart. The efficient level of output corresponds to the first-best allocation in the economy, i.e. the output achieved when there are no nominal rigidities or imperfections present. Galí further shows how this output gap can be derived using only the observed variables of the unemployment rate and the labour income share.
The chart below depicts the efficiency gap in the US economy. Note, that this definition does not allow positive values. It is clear from the figure that at present there is significant economic slack in the US economy of historic dimension. The US output gap is currently almost 6.5% and undershoots its natural historical mean by more than 1.5%-points.
Hence, the present price level gap and output gap reveal that the Federal Reserve has not conducted optimal monetary policy during the Great Recession. Furthermore, the analysis suggest that Fed can easily increase inflation expectations by committing to closing the price level gap. This should give the desired boost to demand and spending and further close the output gap.
Clarida, et al. (1999), “The Science of Monetary Policy: A New Keynesian Perspective”
Galí (2011), “Unemployment Fluctuations and Stabilization Policies: A New Keynesian Perspective”
Pedersen (2011), “Price Level Targeting: Optimal Anchoring of Expectations in a New Keynesian Model”
Vestin (2006), “Price Level Targeting versus Inflation Targeting
Woodford (2003), “Interest and Prices”