Price-level targeting when there is price-level drift

Abstract

Abstract:Recent research has shown that optimal monetary policy may display considerable price-level drift. Proponents of price-level targeting have argued that the costs of eliminating the price-level drift may be reduced if the central bank responds flexibly by returning the price level only gradually to the target path (Gaspar et al., 2010). We revisit this argument in two variants of the New Keynesian model. We show that in a two-sector version of the model which allows for changes in relative prices across sectors, the costs of stabilisation under price-level targeting remain much higher than under inflation targeting for all policy-relevant horizons. Our conclusion is that extending the policy horizon is not a panacea to reduce the costs of eliminating pricelevel drift.Keywords: price-level targeting, optimal monetary policy, commitment JEL-Classification: E58, E42, E31 Non technical summaryIn the canonical New Keynesian model, the optimal monetary policy response to shocks implies a stationary price level. This remarkable result has been put forward as an argument in favour of price-level targeting. However, the optimality of a stationary price level is a very special result, and recent research has shown that optimal monetary policy may display price-level drift if the canonical model is only slightly modified.If optimal monetary policy involves a non-stationary price level, reverting the price level to the target path will inevitably stabilise prices too much and, consequently, lead to higher volatility of other variables. Yet, to our knowledge, the potential costs of eliminating price-level drift have not been analysed systematically so far. Instead, proponents of price-level targeting have argued that the costs of eliminating the pricelevel drift may decline if the central bank responds flexibly by returning the price level only gradually to its steady state. In this paper we show one example in which the argument is correct and one example in which it is not.In our first example, a New Keynesian model with price-level drift, we find that (i) bringing back the price level to its target at a very short policy horizon leads to high volatility and welfare costs, (ii) inflation targeting is better than price-level targeting for policy horizons longer than two quarters, but (iii) for a policy horizon of two years or longer the costs of stabilisation under price-level targeting are not notably higher than those under inflation targeting.In our second example, a two-sector extension of the New Keynesian model, we illustrate that the costs of stabilisation under price-level targeting remain high over a policy-relevant horizon. Specifically, we find that (i) targeting the price level or the inflation rate at short policy horizons leads to high volatility in other welfare-relevant variables and thus to high welfare losses, (ii) inflation targeting is better than price-level targeting for policy horizons longer than two quarters, and (iii) in contrast to inflation targeting the costs of stabilisation under price...

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“…Erceg et al (2000) note that if there is more than one source of nominal rigidity in the economy, then it is optimal to target most forcefully the wage or price that is most rigid. In the baseline calibration of the Gerberding et al (2012) model, consumer prices are only slightly more rigid than intermediate goods prices, so it is highly suboptimal to focus solely on stabilisation of consumer prices as under PT. 16.…”

“…Finally, Gerberding et al . () consider a New Keynesian model with nominal rigidity in both the intermediate goods sector and the final goods sector and show that PT performs poorly. The reasoning is that PT makes the price level in the final goods sector stationary, whereas under the optimal policy there is considerable base‐level drift in the price level after a sector‐specific negative productivity shock.…”

“…In the baseline calibration of the Gerberding et al . () model, consumer prices are only slightly more rigid than intermediate goods prices, so it is highly suboptimal to focus solely on stabilisation of consumer prices as under PT.…”

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“…However, it is doubtful whether a change in the target specification in the event of acute deflationary risk would be suitable for achieving the desired positive effect on private sector inflation expectations (Walsh, 2010). A more serious problem is that a strategy of price-level targeting is associated with a few additional drawbacks compared with optimal monetary policy, casting doubt on whether such a change of strategy would be beneficial (see Deutsche Bundesbank, 2011a, andGerberding, Gerke, andHammermann, 2010).…”

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