By Stephen Snudden, JDI Student Fellow, Queen’s University

Monetary policy may focus on price level targeting (PLT) or inflation targeting (IT). The distinction between the two frameworks is that under IT, the central bank does not respond to temporary deviation of prices from trend. Bygones are bygones. In contrast, with PLT, past inflation performance matters and past deviations must be undone to restore the price level to the target path.

PLT is often discussed as an improvement on IT policy. PLT is seen as a remedy to lift countries off the lower bound on nominal policy rates.  Studies generally find that PLT outperforms IT when the central bank commits to simple interest rate rules (for a survey, see Hatcher and Minford, 2016).

PLT was a major research priority leading up to the renewal of the Bank of Canada’s IT monetary policy framework in 2016 (Bank of Canada, 2017). The complications associated with targeting the price level in the presence of persistent terms-of-trade shocks became a thorn in PLT’s side (Bank of Canada, 2006; 2011). In particular, research we conducted in Coletti et al (2012) found that PLT is inferior to IT in the presence of foreign and persistent energy related terms-of-trade shocks.

The terms of trade for small-open commodity exporters, such as Canada, are dominated by fluctuations in commodity prices. These fluctuations are mostly driven by changes in supply and demand in global market for crude oil (Kilian, 2009; Kilian and Murphy, 2014) for which the Bank of Canada has almost no effect.  Shocks to the global market for crude oil can cause large and persistent real oil price changes, which pass though into headline inflation. Under PLT, the central bank must reverse the effects of such shocks on aggregate prices by generating offsetting price level movements from mainly non-commodity sectors. The required price reversal from oil price driven terms of trade movements is found to be too costly in terms of output and inflation variability.

The analysis in Coletti et al (2012) is the first to compare IT with PLT in a macroeconomic model with endogenous global markets for crude oil and non-oil commodities. The model is a multi-region, multi-sector DSGE model. The model incorporates richness in international trade fluctuations, exchange rates, and current accounts from both demand and supply-driven commodity price movements. Modeling the open-economy dimension and being able to distinguish between the sources of the commodity price movements is found to be critical when comparing the relative merits of the two regimes.

Another novel feature of the study is the consumption of gasoline by household, in addition to the use of crude oil by firms in intermediate production. Both the consumption of the good by the households and the different ability to substitute a commodity in production and across regions are key distinguishing features of oil versus non-oil commodities markets. The consumption of gasoline results in the inflation-output trade-off being larger for oil-driven terms-of trade movements versus non-oil terms-of-trade movements. In the presence of shocks to the global market of crude oil, PLT is found to be inferior to IT for stabilization of the macroeconomy. In contrast, PLT is found to be superior to relative price shocks to non-oil commodities. The difference is driven by lower pass through of the commodity price into headline inflation. This is confirmed by Coletti, et al (2008) who also find that PLT is superior for non-oil terms-of-trade shocks.

The desirability of IT over PLT for oil-price driven terms-of-trade movements is very robust. The volatility associated with PLT are found to be increasing in: 1) the supply and demand real adjustment costs of energy and non-energy commodities, 2) the level of indexation of prices and nominal wages, and 3) the share of energy consumption in the consumption basket. Results are robust to targeting headline or core CPI inflation.

The results illustrate how PLT could prove destabilizing to the economy and damaging to the central bank’s credibility if an economy is subject to persistent terms-of-trade shocks.

References:

Bank of Canada (2006) Renewal of the Inflation-Control Target: Background Information, Ottawa, Bank of Canada.

Bank of Canada (2011) Renewal of the Inflation-Control Target: Background Information, Ottawa, Bank of Canada.

Bank of Canada (2017) Renewing Canada’s Inflation-Control Agreement, Ottawa, Bank of Canada, Accessed March 29^th 2017.

Coletti, D., R. Lalonde, P. Masson, D. Muir, and S. Snudden. 2012. Commodities and Monetary Policy: Implications for Inflation and Price Level Targeting, Bank of Canada Working Paper 2012-16.

Coletti, D., R. Lalonde, and D. Muir (2008) Inflation Targeting and Price-Level Path Targeting in the Global Economy Model: Some Open Economy Considerations. IMF Staff Papers, 55(2): 326-38.

Hatcher, M., and Minford, P. (2016). Stabilisation Policy, Rational Expectations and Price‐Level versus Inflation Targeting: A Survey. Journal of Economic Surveys, 30: 327–355.

Kilian, L. (2009), Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market, American Economic Review, 99(3), 1053-69.

Image from Coletti et al 2012.