Rate and Level Targeting

Evan Soltas always offers plenty of interesting topics to talk about, and his recent post on level and rate targeting is no different. Evan strikes as the fundamental problem with looking at unemployment and the rate of price growth (ie inflation) to determine monetary policy: the Fed has the rates and levels mixed up. From his post:

Third, given a mixed rate/level targeting regime, the Fed has what should be the rate and what should be the level backward. In the long run, the Fed has almost no control over the unemployment rate, yet almost total control over the price level; in the short run, it does have some control over real variables such as unemployment. Given those constraints, it makes far more sense to level-target the variable which the Fed controls in the long and short runs, i.e. the price level, and to rate-target the variable over which the Fed has some control in the short run, i.e. change in nonfarm payroll employment or quarterly real output growth.

This another example of a pragmatic near-term policy that the Fed could pursue. Instead of creating new NGDP futures markets or shifting the focus on to market forecasts, the Fed could just focus on rate changes in employment and the level of prices.

Evan, in his posts, points out an interesting mathematical discrepancy with unemployment-inflation targeting: unemployment is a level, while inflation is a rate of growth. The units don't even match up, the classic problem of physicists everywhere! His adjustment to focus on changes in employment and the level of prices has support from another empirical "rule of thumb": Okun's law. Okun's law relates the rate change in unemployment with the real GDP growth in that period. Historically, the economy needs about 3% real growth every year to maintain the unemployment rate, and every 1% increase in real growth every year can reduce the unemployment rate in that year by about 1%.

Thus, the rate change in unemployment could be used as a quick flash estimate of NGDP growth. This could then be wrapped up in a new targeting regime, as policy makers may pursue higher inflation rates or faster falls in unemployment to reach some hybrid index, which the Fed could target as if in an NGDP level tareting regime. Now that you mention it, it smells suspiciously like Evan's old H-Value proposal, just implemented with a different data source, with unemployment as a proxy for GDP growth. The data frequency argument is a pretty important one against NGDP targeting, so any alternatives for more intermediate data are always important.