Price Level Targeting: An Example

In my previous post, I tried to make a case for using price level targets as a way to overcome the problem of money hoarding (which, under present circumstances, should be understood to include T-bill hoarding, and perhaps Treasury security hoarding in general). In this post I’m going to give an example of what a set of price targets might be and how it would work. You might even consider this a recommendation – although I wouldn’t recommend myself as the best person to recommend a specific set of price level targets.

In general, there are four characteristics that a good set of price level targets should have:

1. It should be realistic. We might love to see a 3 percent inflation rate for 2009, but that’s not going to happen, no matter what the Fed does. To be credible, the targets must allow for a couple of years of low inflation, simply because we know that the Fed has little influence over the inflation rate in the short run. In general, the targets should be reasonably conservative relative to what might be possible, because, if the early targets are not hit, the Fed will have more difficulty hitting the later targets. We don’t want to set the Fed an impossible task in the case where things go badly at first.
   
   
2. It should target prices high enough to make people nervous, even if they don’t think the Fed can hit those targets. This is where my poker game analogy (as discussed in the previous post) comes in. You may think that the player with the four hearts up is probably bluffing, but if she throws enough blue chips into the pot, and if you’re a conservative player, you’re going to fold your three aces anyway. These days almost everyone is a conservative player. So if the Fed sets the price level target high enough, just the risk that it might hit that target should be enough to motivate investors to hold nonmonetary assets. The choice today is between risky assets with a high expected return (stocks, high-yield bonds, etc.) and safe assets with a low expected return (cash, Treasuries, etc.). Set a price level target high enough, and the choice – even if you don’t have much confidence in the Fed’s ability to hit its targets – will be between two risky assets, one with a high expected return and the other with a low expected return.
   
   
3. It should transition to a “normal” rate of inflation in the long run. A normal rate of inflation used to be 2 percent, but recent experience shows that 2 percent is dangerously close to zero. I think 3 percent is the lowest reasonable target for a long-run inflation rate, and that’s what I will assume in my example, because it’s close to what most people would think of as normal. If it were up to me, I would choose a long-run inflation target of 4 or 5 percent. (I’m using the phrase “inflation target” loosely. I mean the inflation rate implied by long-horizon price-level targets.) It’s an open question how long exactly the long run is. In my example, I’m choosing a set of targets that implies a 3 percent inflation rate starting in year 14 (2022, since 2009 is year 1). Note that the 3 percent implication is conditional on earlier targets being met. If the Fed falls short of the price target for the end of 2021, the inflation rate will have to remain higher than 3 percent for a while thereafter in order to catch up.
   
   
4. It should target prices low enough that they don’t imply ridiculously high inflation rates. After a while it should be technically feasible for the Fed to engineer an inflation rate as high as, say, 20 percent, and if that were expected to happen, it would certainly discourage people from holding monetary assets. But at some point the cure becomes worse than the disease. If we’re targeting a long-run implied inflation rate of 3 percent, the transition from 20 percent to 3 percent would likely be very unpleasant. And at some point also, it becomes too unfair to ask today’s long-horizon creditors and fixed income recipients to bear such a large part of the burden for fixing the economy. The targets in my example imply a maximum annual inflation rate of 10 percent (conditional on earlier targets being met), a maximum (conditional) 5-year average inflation rate of 8.4 percent, and a maximum (conditional) 10-year average inflation rate of 6.7 percent. I would say that those are high (as point 2 requires) but not ridiculously high. (Others may have a different opinion.)

The targets in my example are for the core CPI (Consumer Price Index excluding food and energy), and there is a target for each December over the next 20 years. The targets may be understood relative to the actual reported core CPI (216.1) for December 2008. The table below shows the targets and their implications:

A	B	C	D	E	F	G
	price	implied	implied	implied	implied	implied
	target	annual	average	inflation	inflation	average
	core	inflation	inflation	target	target	inflation
	CPI)	target	target	over	over	target
			from	prior	prior	from
			year zero	5 years	10 years	year 5
						assuming
2008	216.1					zero
2009	219.3	1.5%	1.5%			inflation
2010	223.7	2.0%	1.7%			from
2011	230.4	3.0%	2.2%			year 0
2012	239.7	4.0%	2.6%			to year 5
2013	254.0	6.0%	3.3%	3.3%
2014	274.4	8.0%	4.1%	4.6%		27.0%
2015	301.8	10.0%	4.9%	6.2%		18.2%
2016	329.0	9.0%	5.4%	7.4%		15.0%
2017	355.3	8.0%	5.7%	8.2%		13.2%
2018	380.1	7.0%	5.8%	8.4%	5.8%	12.0%
2019	403.0	6.0%	5.8%	8.0%	6.3%	10.9%
2020	423.1	5.0%	5.8%	7.0%	6.6%	10.1%
2021	440.0	4.0%	5.6%	6.0%	6.7%	9.3%
2022	453.2	3.0%	5.4%	5.0%	6.6%	8.6%
2023	466.8	3.0%	5.3%	4.2%	6.3%	8.0%
2024	480.8	3.0%	5.1%	3.6%	5.8%	7.5%
2025	495.3	3.0%	5.0%	3.2%	5.1%	7.2%
2026	510.1	3.0%	4.9%	3.0%	4.5%	6.8%
2027	525.4	3.0%	4.8%	3.0%	4.0%	6.6%
2028	541.2	3.0%	4.7%	3.0%	3.6%	6.3%

These targets imply a 5.8 percent average annual (compound) inflation rate over the next 10 years. (See the entry for December 2018 in column D.) Suppose the Fed were also to target the 10-year Treasury yield at zero (a target the Fed could certainly achieve by intervening directly in the longer term Treasury market, although meeting that target could conceivably require the Fed to buy up almost all of the national debt). The result, if the Fed were to hit its price level targets, would be a real (inflation adjusted) 10-year Treasury return of -5.8 percent.

Markets would not have full confidence in the Fed’s ability to hit its price targets, but the threat of a -5.8 percent real return, even with only limited credibility, should be enough to make people nervous. And the more nervous people get about holding monetary assets (in which term I mean to include Treasury notes), the more they will invest in real assets (or just spend money), and the easier it will be for the Fed to hit its target. It might not be necessary to set the target real return as low as -5.8 percent (i.e. to target the 10-year Treasury yield at zero), but the price level targets would give the Fed room to maneuver.

To get an idea of how the “catch up” process would work with these targets, consider the case where the average inflation rate over the first 5 years is zero. In December 2013, the Fed will miss the target by a factor of 0.85 (the actual core CPI of 216.1 divided by the target of 254.0). The Fed will then have to make to make up that 15 percent “deficit” over the subsequent years by pushing the inflation rate above the original “planned for” inflation rates. Column G shows the average annual inflation rates that would be necessary to make up the deficit in a given number of years. To make it up in one year (obviously unrealistic) would require an inflation rate of 27 percent. To make it up in five years (fairly realistic) would require an inflation rate of 12 percent.

To get an idea of the overall pattern of inflation rates implied by this set of targets, we can divide the next 20 years into 5-year intervals and look at what the average inflation rate would be in each of those intervals if all targets are hit:

• Dec-2008 to Dec2013   3.3%
  
• Dec-2003 to Dec2018   8.4%
  
• Dec-2018 to Dec2023   4.2%
  
• Dec-2023 to Dec2028   3.0%

So the major “push” comes in the second five-year period. The inflation rate over the first 5 years has to be relatively low just because the inflation rate is currently low, and it’s difficult or impossible to increase the inflation rate very quickly. Over the following 5 years, the inflation rate rises to its peak of 10 percent in 2015 and then gradually comes down thereafter.

The hope is that the transition from high to normal inflation (after 2015) will not be too difficult, because it will be fully anticipated. Individual businesses will expect a slowdown in the overall inflation rate and will therefore slow down their own price and wage growth, allowing the anticipated monetary policy to support a normal level of output and employment. That’s the theory, anyhow.




DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

A Con Game Too Successful for Its Own Good

As long as you’re willing to assume that the world will end some day and that the end will be known in advance, it’s a simple matter to prove by induction that money is worthless.

Consider the last minute of the world. If you were living in that last minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it, so what good would it be to you? In the world’s last minute nobody will accept money as payment and therefore it will have no value to anyone: it will be worthless.

Now consider some minute in time where it is known that money will be worthless a minute later. If you were living in that minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it before it becomes worthless, so what good would it be to you? A minute before money is to become worthless, it will already be worthless.

Therefore, according to the principle of mathematical induction, money is always worthless. It will be worthless at the world’s last minute; it will therefore be worthless a minute before that; it will therefore be worthless a minute before that; and so on. Go back as many minutes as you need to go back, and you can get to any point in time and show that money is worthless at that point in time.

Thus, fundamentally, money is worthless right now. But even people like me, who are well aware of this proof, are willing to accept money as payment despite its fundamental worthlessness. Money is valuable to us because we expect it to be valuable to someone else. And since we are reasonably confident in the monetary authorities’ ability to recruit new generations of victims in this endless Ponzi scheme, we willingly allow ourselves to become victims. All of which is very convenient because it allows us to use money as a medium of exchange, a unit of account, and sometimes even a store of value. And it allows authorities to manage the supply of money so as to minimize the frequency and severity of economic downturns.

It’s a nice con game, one where we may rightly cheer the operators, given that the success of their game normally results in benefits for everyone involved. Sometimes, usually in small countries where monetary authorities have limited credibility, we see the con game fail, and generally we lament that failure.

But the other danger is that the game can be too successful. If people become too confident in the value of money relative to other assets, the result is hoarding of money and eventually deflation. And since money is neither productive (like a factory) nor useful (like food), the hoarding of something unproductive and useless supplants the creation of productive and useful things. Accordingly, the operators of the game always suffer from a very rational fear of success. And today, it would appear, their fear is coming true.

But this is crazy. There must be a way to stop rational people from hoarding endless amounts of an asset they know is fundamentally worthless. There must be a way to blow the whistle on this con game.

The solution, it seems to me, is to have the operators come clean – not come clean entirely, not admit that money is completely worthless, but declare in no uncertain terms their intention to cheat us out of quite a lot if we persist in having so much confidence in their scheme. Of course even that approach may not work – it’s possible that our collective gullibility has no limits – but it certainly seems worth a try.

What I’m suggesting is something that has already been suggested – in rather less shocking terms, perhaps – by various other economists (as for example in these posts by Greg Mankiw and Nick Rowe): the Fed should announce a price level target for some point in the future. And it should make that target high enough to scare people (and institutions) out of hoarding money.

It’s still a game of chance. Nobody can be sure that the Fed will be able to hit its price level target, or even get anywhere near it. As I said, in terms of the Ponzi scheme, there may be no limit to our collective gullibility. But let’s shift metaphors here: when you’re playing five card stud and you see that one of the other players has four hearts showing, even if you know the odds are against that player’s having a full flush, you’ve got to have a fair amount of guts to make a big bet on your three aces. And guts are in short supply these days. Nobody will know whether the Fed is bluffing; even the Fed itself won’t know whether it’s bluffing; but if the price level target is high enough, if the player with the four hearts throws enough blue chips into the pot, a lot of today’s ultra-risk-averse investors are going to fold.

And if enough of them fold – OK, here I have to shift the metaphor a little bit again, or maybe you have to think about hundreds of poker games being played at once, with some kind of arrangement where the house is allowed to pass cards from one game to another when the players in the first game fold – if enough investors fold, the game is over. If enough investors give up thinking that their three aces, a.k.a.money (or zero-yield T-bills), are a safe asset, if enough investors start instead buying assets that are productive or useful, then the slack in the economy will diminish and eventually give the Fed a chance to push up prices by creating excess demand. And then the Fed can hit its price target and win the pot.



DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Why are the Fed and the Treasury Working Against Each Other?

It seems like every other day the last couple of weeks I read about how long Treasuries are tanking because markets are “worried about supply.” Then I read about how the Fed is saying they plan to buy long Treasuries, and they’re trying like heck to convince the markets that it’s really gonna happen, but the markets don’t quite believe it.

Maybe there’s a good reason that the markets don’t quite believe it: it doesn’t make any sense. The Treasury is going to issue a crapload of new long bonds, and the Fed is going to buy them back on the open market? Why? If the Treasury just issued short-term bills, the Fed would buy them anyway. At least it would buy enough to keep the federal funds rate near zero, and after that it doesn’t matter. And when the recession, or the potentially deflationary episode, or whatever it is, ends and the Fed wants to stop rolling over the bills, the Treasury can replace them with long bonds if it so chooses.

Now, you might say, “Ah, but when the recession, or the potentially deflationary episode, or whatever it is, ends, long term interest rates will go up, and the Treasury will have to pay more to borrow than it does now, so why not issue them now while the rates are cheap?” That reasoning seems to make sense, until you realize that the Fed, when this episode ends, is going to want to liquidate its long-term bond portfolio, and if rates have risen, it will have to do so at a loss. Since the Fed’s profits go directly into the Treasury, the loss passes right through, and, in terms of present value, it’s (almost) exactly as if the Treasury had issued new debt at a higher yield. Or the Fed could decide to hold the bonds to maturity, in which case it will be just as if the Treasury had never issued them. (In that case, if the Fed wants to reduce the money supply, it could stop rolling over its T-bills, in which case the Treasury will have to issue new ones at higher rates, just as it would have if it had not issued the long bonds in the first place.)

There are only two differences I can see between, on the one hand, having the Treasury issue long bonds and the Fed buy long bonds, and, on the other hand, having the Treasury never issue the bonds in the first place. And neither difference is really a difference. The first difference is that the Fed might buy seasoned bonds in addition to (or instead of) on-the-run issues. The Treasury, by definition, can only issue on-the-run bonds. But this, as I said, is not really a difference: the Treasury can just as well decide to retire its old bonds as to refrain from issuing new ones. Although most Treasury issues are not callable, the Treasury can retire them at market prices, and it will be just as if the Fed had bought them. And in any case, how much difference is there really between on-the-run and seasoned issues? The maturities are slightly different – no big deal in the grand scheme of things – and on-the-run issues are more liquid – a little bit more liquid, but it’s not like seasoned Treasuries sit on your books unintentionally for months because you can’t catch a bid. It’s a technical difference – one that will affect the details that Treasury traders care about, but not the sort of thing that should make headlines.

The other difference is between current policy and future policy. If future policymakers will be somehow influenced by the distribution of securities between the Treasury and the Fed, then that distribution will of course make a difference. But why should they be influenced by it? I can understand that the Fed and the Treasury may perceive themselves as having different interests, but in this case it doesn’t matter, because each one can undo what the other one does. If the Fed sells off its long bonds 5 years from now, the Treasury can stop issuing long bonds. If the Fed holds onto its long bonds, the Treasury can issue more of them. And if the Fed never buys the long bonds in the first place, then the Treasury can do whatever it wants with its finance policy 5 years from now. Again, there are the technical questions about maturity and liquidity, but I don’t see how these are going to make a difference that macro policy makers or investors (as opposed to traders) should care about. And since the timing of these events is unknown, I’m not even sure anyone would be able to make a reasonable guess as to how these technical matters will play out, so perhaps noone at all should care about them.

So what’s going on here? I really don’t get it. Are the Treasury and the Fed really going to insist on working against each other? Is one of them bluffing? (And if so, which one?) Have the markets misinterpreted their signals? Have the markets, in fact, correctly interpreted their signals as being meaningless?


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.