Price-level targeting – the next big idea?

If the next government, of whatever colour, insists on not taking the bold step of getting the government out of the production and management of the money supply – and political realism leads me to the view that this is an unlikely move – then it could do worse than following the advice of Steve Ambler, former Bank of Canada special advisor, and move to price-level targeting. The idea is described in detail in the current edition of Economic Affairs.

There are two main advantages of price-level targeting. The first is that we can set up contracts in nominal (cash) terms today and have a stronger expectation that they will not be eroded by inflation. At the moment, if the Bank of England makes a mistake, and (say) inflation is 10% next year, then bygones are bygones. The price level will move up to 110 and inflation targeting will continue without the Bank trying to get the price level back down again. Under a price-level target, the Bank would have to take action to get the price level down again. This is much better for investment and labour market stability because it makes it less likely that wages or bond interest, over a long period, will be worth less (or more) than we expected.  

Secondly, price-level targeting helps the central bank avoid deflation traps. If the price level drops to 90 next year, then the Bank of England will have to get it back up to 100 (i.e. inflation will have to be about 11% over a period). This means that when interest rates are set at (say) 1%, a real rate of interest of -10% is being signalled – and a negative real rate of interest is just what you need to get rid of deflation.  

Price-level targeting would probably help to improve monetary stability – it certainly helps improve price stability. However, it cannot prevent reckless expansion of the money supply of the sort that creates financial bubbles. It is not a cure all. However, price-level targeting must surely be better than the current system of inflation targeting. This is not just the IEA author’s conclusion. Policy Exchange’s Andrew Lilico has been advocating this for some time (including in his earliest think-tank writings which were for the IEA). If the wonks are thinking about this, then why has the Bank of England not been as active as the Bank of Canada in promoting research in this area? It is being left behind.

So many things wrong with this, Philip.1. If a company is foolish enough to enter an un-indexed multi-year contract and inflation then undermines the value to the seller (or deflation exaggerates the cost to the purchaser), cash-flow realities will likely make it little consolation that the central bank is under obligation to bring the “price-level” back in line with a hypothetically-ideal “price-level” trajectory in the long-run. As the more intelligent of the articles referenced in footnote 2 of Ambler’s article points out, it’s not exactly difficult to include indexation in a contract. Failure to do so could be considered (like tickets for the National Lottery) the price of stupidity.

2. Price-level targeting is based on a false conception of the nature and effect of inflation, just as much as inflation-targeting. As Austrians (and any half-decent observer of reality) know, inflation is the result of monetary expansion, and does not result in a general and even increase in prices across the board, but in benefits to some groups and to the prices of some goods, ahead of others (who are thereby disadvantaged). Both the boom before the Great Crash and the recent “Great Moderation” were accompanied by modest levels of consumer-goods price-inflation, but led eventually to bubbles in the prices of certain goods or assets, which are often ignored by the relevant indices.

3. Price-level targeting seems to assume that central banks’ levers work so well that inflation or deflation can easily be brought back under control in short order once they realise their mistake. History does not support this view. Indeed, if inflation/deflation were so easily controllable, we need not worry about it getting out of control in the first place. If there is a risk of sustained inflation or deflation, price-level targeting would result in ever-more aggressive intervention by central banks, which would risk a more damaging correction. What policy should Japan or Zimbabwe pursue if they followed the price-level targeting philosophy?

One of our problems is that, since it became received wisdom that BoE independence was the right option, we have tried to fool ourselves that the BoE can control monetary effects regardless of the policies and actions of others. This is a delusion that is starting to be exposed, and from which we need to awake. The critical problem for our currency is not the BoE’s actions, but the actions of our Government, both directly (e.g. fiscal stimuli and deficits) and indirectly (through choices on regulation, competition policy, spending, taxation, etc.). Price-level targeting will do no more than inflation-targeting to compensate for a stupid and irresponsible Chancellor.

Which goods should be in a price index, how should they be weighted, and how should that weighting change to reflect changed economic conditions? Is generalization possible, let alone wise? I realise that people can come up with arbitrary solutions once they have decided that something is desirable. But that is looking at it back to front. If I fall off a cliff, it is desirable that I be able to fly. But no amount of flapping my arms will change the laws of physics. The desirability of something provides no justification for overlooking its impossibility. The correct logic is: knowing that I cannot fly, I should not walk too close to the edge of the cliff. We should not rely on price indices.

So many things wrong with this, Philip.1. If a company is foolish enough to enter an un-indexed multi-year contract and inflation then undermines the value to the seller (or deflation exaggerates the cost to the purchaser), cash-flow realities will likely make it little consolation that the central bank is under obligation to bring the “price-level” back in line with a hypothetically-ideal “price-level” trajectory in the long-run. As the more intelligent of the articles referenced in footnote 2 of Ambler’s article points out, it’s not exactly difficult to include indexation in a contract. Failure to do so could be considered (like tickets for the National Lottery) the price of stupidity.

2. Price-level targeting is based on a false conception of the nature and effect of inflation, just as much as inflation-targeting. As Austrians (and any half-decent observer of reality) know, inflation is the result of monetary expansion, and does not result in a general and even increase in prices across the board, but in benefits to some groups and to the prices of some goods, ahead of others (who are thereby disadvantaged). Both the boom before the Great Crash and the recent “Great Moderation” were accompanied by modest levels of consumer-goods price-inflation, but led eventually to bubbles in the prices of certain goods or assets, which are often ignored by the relevant indices.

3. Price-level targeting seems to assume that central banks’ levers work so well that inflation or deflation can easily be brought back under control in short order once they realise their mistake. History does not support this view. Indeed, if inflation/deflation were so easily controllable, we need not worry about it getting out of control in the first place. If there is a risk of sustained inflation or deflation, price-level targeting would result in ever-more aggressive intervention by central banks, which would risk a more damaging correction. What policy should Japan or Zimbabwe pursue if they followed the price-level targeting philosophy?

One of our problems is that, since it became received wisdom that BoE independence was the right option, we have tried to fool ourselves that the BoE can control monetary effects regardless of the policies and actions of others. This is a delusion that is starting to be exposed, and from which we need to awake. The critical problem for our currency is not the BoE’s actions, but the actions of our Government, both directly (e.g. fiscal stimuli and deficits) and indirectly (through choices on regulation, competition policy, spending, taxation, etc.). Price-level targeting will do no more than inflation-targeting to compensate for a stupid and irresponsible Chancellor.

Which goods should be in a price index, how should they be weighted, and how should that weighting change to reflect changed economic conditions? Is generalization possible, let alone wise? I realise that people can come up with arbitrary solutions once they have decided that something is desirable. But that is looking at it back to front. If I fall off a cliff, it is desirable that I be able to fly. But no amount of flapping my arms will change the laws of physics. The desirability of something provides no justification for overlooking its impossibility. The correct logic is: knowing that I cannot fly, I should not walk too close to the edge of the cliff. We should not rely on price indices.

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