Page 11 - ISQ UK_October 2017

APRIL 2019
The Case for Price-Level Targets

Inflation is the rise in the general price level (the Consumer Price Index or PCE Price Index) over time. It can be
too low as well as too high. By law, the Federal Reserve (Fed) is tasked with price stability, but that doesn’t
mean 0% inflation. Having sought a generally low level of inflation for many years, the Fed formally adopted
an inflation-targeting framework in 2012, setting a goal of 2% per year for the PCE Price Index.

Inflation is driven by inflation expectations and by the amount of slack in the economy. The Fed’s success in
anchoring inflation expectations appears to have reduced inflation’s sensitivity to the amount of slack in the
economy. A low unemployment rate has not pushed inflation significantly higher, as it had in the past.
Moreover, financial market participants may have come to view the 2% goal as a ceiling on inflation, rather
than as a target, pushing inflation expectations below 2%. In any case, the Fed has consistently undershot its
2% inflation goal in recent years and there is some concern that the U.S. may join Japan and Europe in
battling low inflation, or even deflation, on an ongoing basis. A shift to a price-level targeting system would
help, as the Fed would seek a period of higher inflation if we experience a period of sub-2% inflation.

A DEBATE ON THE MONETARY POLICY FRAMEWORK
Powell also said the Fed is considering whether to move to a price- KEY TAKEAWAYS:
level targeting framework when analysing inflation. The Fed has • Economic data is critical to the financial markets.
consistently undershot its 2% target in recent years and market It helps to drive earnings expectations and is a key
participants may view that as a ceiling rather than a goal, pushing factor in Federal Reserve policy decisions.
inflation expectations below 2%. In a price-level targeting system, • There are two major sources of uncertainty in
the Fed would seek to hit an inflation target on average. Hence, a the economic data: statistical error and seasonal
period of sub-2% inflation would be followed by a period of adjustments. The government does a good job with
above-2% inflation. All else equal, that implies the Fed would be seasonal adjustment, but it’s difficult to get it exactly
less inclined to raise short-term interest rates in the short run.
right.
PUTTING IT IN PERSPECTIVE: • For those using the economic data, uncertainty means
THE TREND TRUMPS THE NOISE one should take any reported number with a grain of
salt. It’s best to look at a three-month average, which
Many of the uncertainties we faced at the start of the year have
abated. The government shutdown is behind us. The U.S. may get reduces much of the noise (but does not eliminate it)
a trade deal with China. The Fed seems in no hurry to raise short- and is a better gauge of the underlying trend.
term interest rates and has plans to finish the unwinding of its • The Fed pays a lot of attention to the anecdotal
balance sheet. The question then is what to look for next. Partisan evidence. However, its main focus is on the job market
politics and congressional inquiries could rattle investors’ nerves. and inflation. Based on the demographics, job growth
However, the market focus should eventually get back to the in recent years has been well beyond a long-term
economic data. Yet, the markets often use the economic data as sustainable pace. That’s not a problem in the short
an excuse. What’s more important is how the data fits into the term.
overall narrative.
• The market focus should eventually get back to
the economic data. Yet, the markets often use the
economic data as an excuse. What’s more important
is how the data fits into the overall narrative.

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