Two Decades of Price-Targeting and Two Asset Price Cycles. Is There a Link?
Updated: Jan 28
For the past two decades price targeting has been at the core of the monetary policymaking process. During this period there have been two unprecedented asset prices cycle, involving real and financial prices. That raises the key question— Is there a direct or indirect link between price targeting and asset cycles? The evidence says there is.
Price Targeting - Anchor For Monetary Policy
The practice of monetary policy often includes an anchor or an informal or formal target to gauge how policy decisions are helping policymakers achieve their mandated objectives. In 2000, after abandoning its money targeting policy several years’ earlier, policymakers adopted an informal price-targeting framework, arguing that maintaining price stability is a perquisite for sustainable and maximum growth.
For whatever reason, operational or political, policymakers chose the Bureau of Economic Analysis (BEA) personal consumption expenditure deflator (PCE) for their price target over the Bureau of Labor Statistics (BLS) traditional and widely used consumer price index (CPI).
Regardless of the reason the PCE index gets 70% of its price inputs from the CPI so the two price series would still track one another and any changes in methodology or measurement by BLS would spillover proportionally to the PCE.
That latter point came into play in the 2000s after BLS made an important change in the measurement of owner-housing costs in 1998 (the largest component of the CPI and PCE indexes).
Because of an inadequate and declining sample of owner-occupied housing, BLS statisticians felt the process was “time-consuming” and “futile” as it could no longer provide a consistent and accurate reading of housing costs from the owner-occupied units.
So the remedy, according to BLS, was to linked the price data from the rental market to owner-occupied market, even though the two markets are fundamentally separate. In reality, that change effectively removed the largest cyclical driver of consumer inflation.
Yet, its important to note that BLS never stated that house price inflation was not inflation. That’s not BLS job to define what is inflation. BLS responsibility is to avoid an error in measurement and it’s the responsibility of others---especially policymakers--- to analyze the reported price data, as well as other price data, to ensure policy decisions are producing the expected outcomes.
Had BLS pre-1998 house price measurement practices still been in operation during the house price boom of the 2000s reported CPI and PCE inflation would have been substantially higher. Yet, the exclusion created the wrong impression on underlying inflation resulting in a price targeting policy of keeping official rates too low for too long---directly or indirectly fueling a real estate bubble.
Price-Targeting After Financial Crisis
In 2012, policymakers formally adopted a 2% price-target as an objective of monetary policy. Elevating the price target from an information variable to a formal target meant policymakers would use all of their tools to achieve a 2% increase in the PCE index.
The formal use of a price target transforms monetary policy into a two-stage process. First, policymakers determine the rate of inflation that they believe to be consistent with their mandated objectives on full employment, price and financial stability. And, the second step calls for policymakers to implement changes in official rates and other tools to achieve the price target.
The problem with this approach is two fold: first, it assumes that there is a “perfect” inflation rate, that is stable over time, unaffected by non-monetary or measurement issues; and second, its fails to account for shifts in behavior and unintended economic and financial consequences of a policy trying to achieve a narrow price target.
Since the adoption of a formal price target in 2012, policymakers have never once hit their 2% target in the PCE index (although the 2% mark has been exceeded in traditional CPI index). And in 2019, even with GDP growth exceeding policymakers expectations of 2.3% and the jobless rate declining to 3.5%, the lowest rate in 50 years, policymakers still decided to reduced official rates three times, and promise not to raise official rates until PCE inflation, which is only few decimal points below target, hits the 2% mark on a sustained basis.
Not surprising, these policy actions and promises sent equity prices to record heights---lifting the cumulative gain in the past 5 years to 60% against a backdrop of no growth in operating profits---and in the process lifted the market valuation of domestic companies in relation to Nominal GDP to level seen only once before---at the peak of the tech bubble in 2000.
Time will tell if the surge in equity prices is the second asset bubble directly or indirectly linked to price-targeting, but it appears to have all of the characteristics of the housing bubble---that is, overvaluation, speculation, little risk, and vision of endless gains.
When policymakers abandoned the money growth targets in the mid-1990s, the decision proved to be seamless and costless----since it did not impact the interest rate decisions of monetary policy or directly impact the economy. Yet, if policymakers are forced at some point to abandon price targeting it will because this policy approach failed (again) and there could be huge costs to the credibility of the Federal Reserve, investors and the economy at large.