Why Kocherlakota says price targeting beats inflation targeting

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Nov. 20 2020, Updated 3:46 p.m. ET

Other key suggestions for improving the framework statement

Along with the two suggestions we mentioned in Part 6 of this series, Narayana Kocherlakota also dropped in two additional suggestions for improving the FOMC framework statement:

  1. The FOMC should consider articulating a benchmark two-year time horizon for returning inflation to the 2% goal, as monetary policy is generally thought to affect inflation with about a two-year lag. This move would lead the FOMC to pursue its inflation target with even more alacrity.
  2. The FOMC should consider targeting the price level, as opposed to the inflation rate, as a goal. Kocherlakota rests his case on the fact that the benefits of price level targeting outweigh those of inflation targeting.

Price level targeting versus inflation level targeting

In the present-day U.S., the economy has been hit by a large negative shock to aggregate demand, and nominal interest rates have been zero lower bound in an attempt to stimulate the economy back to full capacity.

Under inflation targeting, inflation expectations remain anchored at 2%—or even lower for households and firms that understand the importance of monetary policy. This raises the real interest rate (nominal interest rate minus inflation expectations), pushing aggregate demand even further town.

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On the other hand, in a price targeting scenario, after the demand shock has hit and inflation is below 2%, a credible price level target would create the expectation of future inflation of more than 2%. In turn, this expectation would lower real interest rates today and provide necessary stimulus to aggregate demand and upward pressure on prices.

The Fed’s communication has evolved

Over the hundred years of its existence, the Federal Reserve has evolved greatly with respect to its public communications. Fed Chair Janet Yellen remarked at the recent FOMC meeting held on September 16–17, “I think the committee would like to feel that it has successfully begun the normalization process and that we are successfully communicating with markets about how that process will be playing out over time.”

The monetary policy decisions made at these FOMC meetings affect fixed income (TLT) and stock (SPY) markets. Fixed income markets include Treasuries (IEF), high-yield (HYG)(JNK) and investment-grade debt, and mortgage-backed securities.

Learn more about the key takeaways from the September FOMC meeting in our Market Realist series Must-know: Key investor takeaways from the Fed’s September FOMC.

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