What Price Level Targeting Could do for Europe

There’s more to asset purchases than size. In addition to announcing large bond purchases of €60 bn per month, ECB president Mario Draghi suggested that asset purchases could continue until the ECB hit its inflation target of 2%.

This resembles QE 3, in which the Fed committed to asset purchases until unemployment fell below 6.5% or inflation rose above 2.5%. It also resembles recent events at the Bank of Japan. When Kuroda saw that the Bank of Japan would not be hitting its inflation target, he had the BOJ raise the rate of asset purchases by 30 tr. yen per year — from 50 to 80 tr yen. If the ECB follows up on this open ended commitment, it could be the bold new start of a “Draghi Framework” in which the ECB commits to hitting its inflation target through asset purchases.

This might not be enough. One problem with monetary policy at the zero lower bound is that the only way to lower real interest rates (without introducing negative paper currency interest rates) is to increase expected inflation. If central banks define their own responsibility in terms of hitting an inflation target, then raising inflation expectations is tantamount to “credibly promising to be irresponsible”. To get people to raise their inflation expectations now, the ECB would need to convince people that the central bank will let inflation run too high for a period in the future — something that’s not credible when the inflation target has historically centered around 1.50–1.75%.

One way around this is to commit not to an inflation target but rather a price level target. Instead of targeting a growth path for the price level, the ECB would instead commit to making sure the price level reaches a predetermined path. So if the ECB undershoots one year, its target would have it try to generate more inflation in the next.

Let’s consider what this means given the history of the price level in the Eurozone.

What’s evident from the graph is that the path of the price level was pretty steady up until 2012, and since then it has leveled off. This collapse in the price level growth rate (aka inflation) is even more stark from looking at year over year inflation rates.

Year over year inflation is negative. An inflation target would commit the central bank to raise that up to 2%. A price level target would commit to raising that level inflation above 2% for an extended period of time in order to fill in the gap caused by the persistent lack of inflation over the course of the last year.

(Ignore the 2012 bump — it was the result of VAT tax changes that should have no relevance for monetary policy)

But the key part of a price level target is that it implies larger and larger levels of inflation if the central bank doesn’t hit its target. If the target is a 2% price level path, and inflation is only 1% this year, that implies that the central bank is committing to a 3% inflation target the year after. If inflation stays at 1%, then the inflation target becomes 4%. If the central bank can do this credibly, then expected inflation increases as the experience at zero lower bound gets longer. This lowers real interest rates and allows the central bank to get more traction.

And why might we think this threat is credible? As I discussed before, if a central bank can’t raise the price level then that would imply absurd abilities to change real economic conditions.

Price level targeting gets around Krugman’s “credible irresponsibility” line because the central bank redefines what it means to be responsible. Higher inflation becomes responsible because it’s done in the name of hitting a price level target.

The ECB made an important step towards restoring nominal stability in the Eurozone with QE. But if the ECB finds itself needing to bring out more firepower, a price level target would be one way for the ECB to get more traction at the zero lower bound.