If QE2 Was Price-Level Targeting, It is Starting to Work
Has QE2 worked? Some say yes, some say no. The answer depends on what you wanted it to do.
If you wanted a quick revival of the housing market, a boost to GDP growth, and rapid job creation, it’s easy to say QE2 has failed. None of those indicators look good. On the other hand, if you thought the purpose of QE2 was to save the country from deflation, then it looks better, especially if you are a fan of price level targeting.
Price-level targeting is the view that central banks should focus their policy on holding the average price level to a preset growth path over an extended period. It resembles the more widely known policy of inflation targeting in assuming that monetary policy should target nominal variables, which it can affect directly, not real variables, which it can affect only indirectly. It differs from inflation targeting in how it deals with situations where inflation falls short of the target. Inflation targeting aims to get inflation back to a target rate, and then ease off. Price-level targeting more aggressively aims for above-target inflation until the price level has fully caught up to its previous path.
Chairman Ben Bernanke has indicated that the Fed considers inflation of about 2 percent per year to be consistent with its mandate, but neither he nor his predecessors have explicitly endorsed any specific form of targeting. As a result, there was a good deal of ambiguity about what the Fed was trying to do when it undertook its second round of quantitative easing in November 2010. Did it intend to bring the price level back to the original path of 2 percent inflation that it had begun to fall below in early 2009? Or did it intend to rebase the target, and aim for 2 percent inflation going forward from the start of QE2? It was hard to tell, as I discussed at the time in this post.
The latest data, shown in the chart, indicate that the outcome of QE2 looks more like price-level targeting than rebasing. (In the chart, and everywhere in the remaining discussion, the Cleveland Fed’s 16 percent trimmed-mean CPI is used to eliminate transient effects of the most volatile CPI components.)
The chart starts in January 2009, just at the point when inflation began to drop below 2 percent. Over the next year and a half, the actual price level fell farther and farther below the original 2 percent path. If QE2 had been intended as classic inflation targeting, its objective would have been get onto and stay on a 2 percent path rebased in November 2010. As the price level rose above the rebased target, as it began to do already in January 2011, the Fed would have had to ease off its expansionary policy in order to prevent excess inflation.
Instead, the Fed continued with the full planned program of QE2, even as inflation rose to 3 percent and above during the late winter and spring of 2011. That outcome was exactly what had been advocated by proponents of price-level targeting, including Charles Evans, head of the Federal Reserve Bank of Chicago, who had become a voting member of the policy-setting Federal Open Market Committee in January.
What now? Judging from the just-released May data, it looks like things are developing as price-level targeters would want them to, but the job is not finished. As the dashed extrapolation of the actual price-level series shows, it would take another three quarters of 4 percent inflation to bring the price level back to the path it dropped below in the depths of the recession.
Will the price level continue to catch up with its earlier trend? At this point, the odds look better than even that it will. Barring some very bad economic numbers over the next few months, the Fed is unlikely to undertake a new round of quantitative easing, but it probably will not have to do so. There ought to be enough of a lag in policy effectiveness to allow inflation to continue above 2 percent for some time yet. To slow inflation more quickly, the Fed would need not just to stop additional asset purchases, but to begin aggressively to reduce its accumulated holdings. It has given no indication that it will do so.
Does this mean we will see a happy ending to the QE2 saga? It is too soon to be sure. It looks like the Fed has administered a dose of expansionary policy large enough to satisfy Dr. Evans, but we don’t know yet if the patient will make a full recovery. We still need to wait a while to see how those annoying real indicators respond to the medicine. If GDP growth is back on track a year from now, with unemployment starting to fall and the housing market out of the intensive care unit, then we can celebrate the triumph of price-level targeting.
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