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PERIODICALS • p* in the Short Run Identifying a simple long-term relationship between p* and the price level is justified on empirical grounds because other variables, particularly nominal interest rates, do not seem to affect the long-term equilibrium value of M2 velocity. While interest rates trended upward over most of the postwar period, there is no clear evidence of any effect on the trend in M2 velocity. On the other hand, evidence strongly suggests that interest rates are important for identifying a short-run relationship between M2 and nominal GNP. Recent research indicates that money demand may be more interest-rate sensitive than previously thought. Figure 4 reveals a close linkage between movements in interest rates and the velocity of M2. Thus, it would appear that interactions among money, nominal income, and interest rates matter in the short-run relationship between P" and the price level. policy. This seems evident in the fact that one of the best predictors of inflation is previous inflation. Including lagged inflation in models designed to predict inflation can be justified if lagged inflation is a reasonable proxy for inflationary expectations. This characterization of the short-run inflation process is troubling because the empirical research supporting the con- difficult to justify sluggish price adjustment on theoretical grounds, most economists find Iittle evidence that prices of goods and services respond immediately to changes in monetary 1. A more complete description of P" and cept are found in Jeffrey J. Hallman, Richard D. Porter, and David H. Small. "M2 per Unit of Potential GNP as an Anchor for the Price nors of the Federal Reserve System. April 1989. choosing among alternative models. Thus, it is difficult to know whether Monetary Policy in an Era of Change, Proceedings from the American Enterprise In- short-run inflation control based on the P" indicator would lead to excessive economic volatility. stitute's Conference of November 16-17, cal evidence supports the view that P" can be a useful indicator in this regard. by John B. Carlson Level," Staff Study No. 157, Board of Gover- tion from targets and goals is discussed by some Federal Reserve officials may have begun to use P" as an indicator for clues concerning the achievement of the price-stability objective. Statisti- The Indicator P-Star: Just What Does It Indicate? Footnotes policy? While there may be plausible economic models that do not display these cyclical effects of monetary policy, there is no sound basis for • Conclusion Recent public statements suggest that Federal Reserve Bank of Cleveland longer perspective to avoid the possibility that short-term policy considerations might interfere with the longerterrn goal of price stability. policy changes to induce business cycles. Indeed, simple models linking Identification of a short-run relationship between P" and the price level is further complicated by the problem that prices often adjust slowly to changing economic conditions. Although it is useful in helping policymakers assess the longer-term consequences of policy actions. It is essential to maintain some • changes in inflation to the difference between P" and the price level-the price gap-indicate a significant potential for cyclical effects of monetary eCONOMIC COMMeNTORY While p* is not without some potential shortcomings, it is likely to be most in any economic model with lagged effects, there is a potential for monetary 2. This notion of an indicator and its distinc- Financial markets pay a great deal of attention to the Federal Reserve System and, in particular, to the deliberations of its key policymaking arm, the Federal Open Market Committee (FOMC). This "Fed watching" focuses largely on anticipating how the FOMC is likely to react to unfolding events in the Bennett T. McCallum in "Targets, Instruments, and Indicators of Monetary Policy," 1988. - 3. See Hallman et al., op. cit. economy, and how such actions become translated into changes in the cost and availability of money and credit. John B. Carlson is an economist at the Federal Reserve Bank of Cleveland. The author wishes to thank Christine Dingledine Specifically, markets are interested in knowing which variables the FOMC considers in assessing whether it is ac- for excellent research assistance. The views stated herein are those of the author and nat necessarily those of the complishing its objectives. These variables are often referred to as indicators. In recent years, Federal Reserve offi- Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. cials have proposed a variety of new monetary indicators, including commodity prices, the trade-weighted value of the dollar, and the yield curve. Most recently, however, the Federal Reserve BULK RATE Postage Paid Cleveland,OH Permit No. 385 u.s. Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland, OH 44101 Address Correction has unveiled P-Star (P*) , an indicator of potential inflation. 1 • What Is an Indicator? An indicator is neither an ultimate objective to be achieved (a goal), nor a stand-in objective to be aimed at (a target). Rather, an indicator is a variable Requested: Please send corrected mailing label to the above address. QUV13t\31Q .:10 )lH\'B )i, '. S ::I1V~303':! 68. HV SO Ot 51 that provides information about whether policy instrument settings are likely to accomplish their specified objectives, which are observed only d3S after a lag. An indicator essentially Material may be reprinted provided that the source is credited. Please send copies September 15, 1989 provides information concerning the current state of the econorny.f If an indicator value is unusually high (or low) on the basis of some historical standard, it could indicate that goal or target variables are likely to miss their marks. A policymaker might then reconsider policy instrument settings to attempt to avoid undesired outcomes. However, policymakers are under no commitment to react in any specified way to changes in the value of an indicator; nor are they committed to seek a specified value. Because policymakers typically look at a variety of indicators, they often observe conflicting signals. Moreover, different policymakers give different weights to different indicators. Thus, it is often difficult to predict how a group of policymakers will react to substantial changes in indicator values. • What Is P*? Simply put, P" is the eventual price level implied by the current level of the M2 monetary aggregate. It is calculated as p* = (M2 x V*)/Q*, where V* is an estimate of the long-run value of the GNP velocity of M2-the mean value from 1955:Q I to I988:Q4-and Q* is a Federal Reserve Board staff measure of potential output. Recent advances in understanding long-term statistical relationships indicate that P" AlPH1811 HOHV3S3H of reprinted materials to the editor. ISSN 0428·1276 Monetary indicators can help policymakers to evaluate the likely success or failure of policy instrument settings. The recently unveiled P-Star indicator can be useful as an indicator of potential inflation and, more broadly, as a method of assessing the Federal Reserve's long-term goal of price stability. and the current price level probably share a common trend. The indicator property, of P" is revealed in figure I. The vertical dotted lines denote the quarters when the current price level (implicit price deflator) and P" cross (top panel). Periods after which P" begins to persistently exceed the current price level are ultimately characterized by rising inflation (bottom panel) . Conversely, periods after which P" begins to persistently remain below the current price level are followed by periods of disinflation. There is a noteworthy variation, however, in the lag between the time the two series cross and the point when inflation changes direction. FIGURE Presently, the level of M2 appears ap- 1 p* AS AN INDICATOR proximately consistent with the current price level. In the first half of 1989, P" OF INFLATION Natural log of price fell slightly, so that p* and the price level are about equal. Given the recent 0.5 p* vs, Implicit Price Deflator 12 Inflation" 10 . • 6 • 2 • o . 1955 a. Inflation is the percentage change in the implicit price deflator from four quarters earlier. - NOTE: The vertical lines in the top and bottom panels mark the quarters when P and P' cross. SOURCES: Board of Governors of Economic Analysis. FIGURE acceleration in M2 in early 1989:Q3 and current money-market interest rates, it is unlikely that P" will continue to fall. Nevertheless, if p* moves 3,800 below the current price level and remains there persistently, then the inflation rate would be expected to fall. 2,300 the money supply ultimately determines the level of prices. Moreover, the P" relationship implies that any particular trend in M2 will be associated of the Federal Reserve System: and U.S. Department of Commerce, Bureau 2,800 Ratio 1.85r---------------------------------------~ 1.80 rently no consensus on a method for assessing ex ante changes in trend output growth: at any time, an estimate of 1,800 potential output may be inappropriate . 1,300~ ...•....• '-!-::~...•....• '-!-::~...•....• ~~ 1955 ...•....• ~~..L..I~~..L..I~~..L..I~ 1990 Percent change, annual rate 4. 0 r-------------------------------------------. 2.52.0'::+ .•...•. ~1~'-'-~1~1"-&...~~ 1955 1960 1965 - SOURCE: What distinguishes p* from.other characterizations of the quantity theory is FIGURE I..L..II~I~ 1970 ••.•.•• ...L::_II~'-'-~I,_!_I"-&...~ 1975 1980 1985 1990 Board of Governors of the Federal Reserve System. 4 M2 VELOCITY AND INTEREST are long and variable lags between money growth rates, it is difficult to find a simple measure of money growth that would reliably indicate the future inflation rate. Differing conclusions may result from choosing different periods over which to calculate money growth rates. P*, on the other Percent 18 16 1.80 14 1.75 independent of both economic factors and the money-supply level. Also, p* 12 is based on a particular estimate of the level of potential output, which is as- 10 1.65 sumed to be independent of policy in the long run. Despite these problems, p* has some advantages over other inflation indicators. For example, because there hand, provides an absolute reference point for the price level. RATES Velocity 1.85r----------------------------------------., measure of money is based on evidence that, over sufficiently long periods, M2 velocity retums to some mean value (see figure 2), and hence is 2 M2 VELOCITY tom panel), however, illustrates how the estimate of potential output growth has changed discretely at different times. These changes have been recognized only after the fact. There is cur- 3,300 with its own unique path for the longrun equilibrium price level. the extent to which it is specified in practical terms, making it somewhat more applicable to real-world policies. For example, the choice of M2 as the OUTPUT Billions of 1982 dollars (log scale) 4,300 • Isn't This Just the Quantity Theory? Economists will recognize P" as a characterization of the quantity theory of money, which states that the level of Percent 8 - FIGURE 3 POTENTIAL ficulty in using such estimates. In terms of levels (top panel), it would appear that the measure of potential output grows rather smoothly. Expressing the measure in growth-rate terms (bot- 8 • p* as a Nominal Anchor It is useful to clarify the distinction between the short-run and long-run implications of P*. By the nature of its construction, p* indicates only the long-run equilibrium level of prices, not what the price level will be in any near-term month or quarter, Such an indicator is particularly useful in a framework within which to evaluate policies for achieving the Federal Reserve's long-term goal of price stability. 1.60 1 • Two Key Assumptions Specification of values for the long-run level of M2 velocity and for potential output is a matter of judgment. Some 6 , 1'\ I t \f3-month Treasury analysts have argued that it is unlikely that M2 velocity was not in some way SOURCES: Board of Governors of the Federal Reserve System: and U.S. Department of Commerce, of Economic Analysis. Bureau 4 bill 1984 1989 affected permanently by deregulation in the early 1980s. They believe that deregulation removed constraints on SOURCE: banks, allowing them to compete more successfully for funds. (not counted as M2) to M2 instruments, including checking accounts velocity estimate is more accurate, then any particular path for the eventual Consequently, one might expect that deregulation led to a portfolio shift of and savings and time deposits. As evidence of such a shift, analysts point to the mean value of M2 velocity in the recent period from 1982:Q4 to price level, P*, would be compatible with a higher path for M2. funds from nondepository instruments Board of Governors of the Federal Reserve System. 1988:Q4, which is somewhat below the longer-term average. If the lower Often the focus of policy is concentrated on immediate real economic conditions. Policymakers naturally seek to avoid economic downturns. However, if policies do not take into account intermediate- and long-term consequences for the price level, even more severe policy restraint may be required later. Having a simple empirical guidepost like P" could serve to anchor nominal spending, limiting its longer-term variability. This, in turn, could limit the potential for policy mistakes and hence the severity of the business cycle. Similarly, some analysts question the measure of potential output used in calculating P*. Figure 3 illustrates the dif- FIGURE Presently, the level of M2 appears ap- 1 p* AS AN INDICATOR proximately consistent with the current price level. In the first half of 1989, P" OF INFLATION Natural log of price fell slightly, so that p* and the price level are about equal. Given the recent 0.5 p* vs, Implicit Price Deflator 12 Inflation" 10 . • 6 • 2 • o . 1955 a. Inflation is the percentage change in the implicit price deflator from four quarters earlier. - NOTE: The vertical lines in the top and bottom panels mark the quarters when P and P' cross. SOURCES: Board of Governors of Economic Analysis. FIGURE acceleration in M2 in early 1989:Q3 and current money-market interest rates, it is unlikely that P" will continue to fall. Nevertheless, if p* moves 3,800 below the current price level and remains there persistently, then the inflation rate would be expected to fall. 2,300 the money supply ultimately determines the level of prices. Moreover, the P" relationship implies that any particular trend in M2 will be associated of the Federal Reserve System: and U.S. Department of Commerce, Bureau 2,800 Ratio 1.85r---------------------------------------~ 1.80 rently no consensus on a method for assessing ex ante changes in trend output growth: at any time, an estimate of 1,800 potential output may be inappropriate . 1,300~ ...•....• '-!-::~...•....• '-!-::~...•....• ~~ 1955 ...•....• ~~..L..I~~..L..I~~..L..I~ 1990 Percent change, annual rate 4. 0 r-------------------------------------------. 2.52.0'::+ .•...•. ~1~'-'-~1~1"-&...~~ 1955 1960 1965 - SOURCE: What distinguishes p* from.other characterizations of the quantity theory is FIGURE I..L..II~I~ 1970 ••.•.•• ...L::_II~'-'-~I,_!_I"-&...~ 1975 1980 1985 1990 Board of Governors of the Federal Reserve System. 4 M2 VELOCITY AND INTEREST are long and variable lags between money growth rates, it is difficult to find a simple measure of money growth that would reliably indicate the future inflation rate. Differing conclusions may result from choosing different periods over which to calculate money growth rates. P*, on the other Percent 18 16 1.80 14 1.75 independent of both economic factors and the money-supply level. Also, p* 12 is based on a particular estimate of the level of potential output, which is as- 10 1.65 sumed to be independent of policy in the long run. Despite these problems, p* has some advantages over other inflation indicators. For example, because there hand, provides an absolute reference point for the price level. RATES Velocity 1.85r----------------------------------------., measure of money is based on evidence that, over sufficiently long periods, M2 velocity retums to some mean value (see figure 2), and hence is 2 M2 VELOCITY tom panel), however, illustrates how the estimate of potential output growth has changed discretely at different times. These changes have been recognized only after the fact. There is cur- 3,300 with its own unique path for the longrun equilibrium price level. the extent to which it is specified in practical terms, making it somewhat more applicable to real-world policies. For example, the choice of M2 as the OUTPUT Billions of 1982 dollars (log scale) 4,300 • Isn't This Just the Quantity Theory? Economists will recognize P" as a characterization of the quantity theory of money, which states that the level of Percent 8 - FIGURE 3 POTENTIAL ficulty in using such estimates. In terms of levels (top panel), it would appear that the measure of potential output grows rather smoothly. Expressing the measure in growth-rate terms (bot- 8 • p* as a Nominal Anchor It is useful to clarify the distinction between the short-run and long-run implications of P*. By the nature of its construction, p* indicates only the long-run equilibrium level of prices, not what the price level will be in any near-term month or quarter, Such an indicator is particularly useful in a framework within which to evaluate policies for achieving the Federal Reserve's long-term goal of price stability. 1.60 1 • Two Key Assumptions Specification of values for the long-run level of M2 velocity and for potential output is a matter of judgment. Some 6 , 1'\ I t \f3-month Treasury analysts have argued that it is unlikely that M2 velocity was not in some way SOURCES: Board of Governors of the Federal Reserve System: and U.S. Department of Commerce, of Economic Analysis. Bureau 4 bill 1984 1989 affected permanently by deregulation in the early 1980s. They believe that deregulation removed constraints on SOURCE: banks, allowing them to compete more successfully for funds. (not counted as M2) to M2 instruments, including checking accounts velocity estimate is more accurate, then any particular path for the eventual Consequently, one might expect that deregulation led to a portfolio shift of and savings and time deposits. As evidence of such a shift, analysts point to the mean value of M2 velocity in the recent period from 1982:Q4 to price level, P*, would be compatible with a higher path for M2. funds from nondepository instruments Board of Governors of the Federal Reserve System. 1988:Q4, which is somewhat below the longer-term average. If the lower Often the focus of policy is concentrated on immediate real economic conditions. Policymakers naturally seek to avoid economic downturns. However, if policies do not take into account intermediate- and long-term consequences for the price level, even more severe policy restraint may be required later. Having a simple empirical guidepost like P" could serve to anchor nominal spending, limiting its longer-term variability. This, in turn, could limit the potential for policy mistakes and hence the severity of the business cycle. Similarly, some analysts question the measure of potential output used in calculating P*. Figure 3 illustrates the dif- PERIODICALS • p* in the Short Run Identifying a simple long-term relationship between p* and the price level is justified on empirical grounds because other variables, particularly nominal interest rates, do not seem to affect the long-term equilibrium value of M2 velocity. While interest rates trended upward over most of the postwar period, there is no clear evidence of any effect on the trend in M2 velocity. On the other hand, evidence strongly suggests that interest rates are important for identifying a short-run relationship between M2 and nominal GNP. Recent research indicates that money demand may be more interest-rate sensitive than previously thought. Figure 4 reveals a close linkage between movements in interest rates and the velocity of M2. Thus, it would appear that interactions among money, nominal income, and interest rates matter in the short-run relationship between P" and the price level. policy. This seems evident in the fact that one of the best predictors of inflation is previous inflation. Including lagged inflation in models designed to predict inflation can be justified if lagged inflation is a reasonable proxy for inflationary expectations. This characterization of the short-run inflation process is troubling because the empirical research supporting the con- difficult to justify sluggish price adjustment on theoretical grounds, most economists find Iittle evidence that prices of goods and services respond immediately to changes in monetary 1. A more complete description of P" and cept are found in Jeffrey J. Hallman, Richard D. Porter, and David H. Small. "M2 per Unit of Potential GNP as an Anchor for the Price nors of the Federal Reserve System. April 1989. choosing among alternative models. Thus, it is difficult to know whether Monetary Policy in an Era of Change, Proceedings from the American Enterprise In- short-run inflation control based on the P" indicator would lead to excessive economic volatility. stitute's Conference of November 16-17, cal evidence supports the view that P" can be a useful indicator in this regard. by John B. Carlson Level," Staff Study No. 157, Board of Gover- tion from targets and goals is discussed by some Federal Reserve officials may have begun to use P" as an indicator for clues concerning the achievement of the price-stability objective. Statisti- The Indicator P-Star: Just What Does It Indicate? Footnotes policy? While there may be plausible economic models that do not display these cyclical effects of monetary policy, there is no sound basis for • Conclusion Recent public statements suggest that Federal Reserve Bank of Cleveland longer perspective to avoid the possibility that short-term policy considerations might interfere with the longerterrn goal of price stability. policy changes to induce business cycles. Indeed, simple models linking Identification of a short-run relationship between P" and the price level is further complicated by the problem that prices often adjust slowly to changing economic conditions. Although it is useful in helping policymakers assess the longer-term consequences of policy actions. It is essential to maintain some • changes in inflation to the difference between P" and the price level-the price gap-indicate a significant potential for cyclical effects of monetary eCONOMIC COMMeNTORY While p* is not without some potential shortcomings, it is likely to be most in any economic model with lagged effects, there is a potential for monetary 2. This notion of an indicator and its distinc- Financial markets pay a great deal of attention to the Federal Reserve System and, in particular, to the deliberations of its key policymaking arm, the Federal Open Market Committee (FOMC). This "Fed watching" focuses largely on anticipating how the FOMC is likely to react to unfolding events in the Bennett T. McCallum in "Targets, Instruments, and Indicators of Monetary Policy," 1988. - 3. See Hallman et al., op. cit. economy, and how such actions become translated into changes in the cost and availability of money and credit. John B. Carlson is an economist at the Federal Reserve Bank of Cleveland. The author wishes to thank Christine Dingledine Specifically, markets are interested in knowing which variables the FOMC considers in assessing whether it is ac- for excellent research assistance. The views stated herein are those of the author and nat necessarily those of the complishing its objectives. These variables are often referred to as indicators. In recent years, Federal Reserve offi- Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. cials have proposed a variety of new monetary indicators, including commodity prices, the trade-weighted value of the dollar, and the yield curve. Most recently, however, the Federal Reserve BULK RATE Postage Paid Cleveland,OH Permit No. 385 u.s. Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland, OH 44101 Address Correction has unveiled P-Star (P*) , an indicator of potential inflation. 1 • What Is an Indicator? An indicator is neither an ultimate objective to be achieved (a goal), nor a stand-in objective to be aimed at (a target). Rather, an indicator is a variable Requested: Please send corrected mailing label to the above address. QUV13t\31Q .:10 )lH\'B )i, '. S ::I1V~303':! 68. HV SO Ot 51 that provides information about whether policy instrument settings are likely to accomplish their specified objectives, which are observed only d3S after a lag. An indicator essentially Material may be reprinted provided that the source is credited. Please send copies September 15, 1989 provides information concerning the current state of the econorny.f If an indicator value is unusually high (or low) on the basis of some historical standard, it could indicate that goal or target variables are likely to miss their marks. A policymaker might then reconsider policy instrument settings to attempt to avoid undesired outcomes. However, policymakers are under no commitment to react in any specified way to changes in the value of an indicator; nor are they committed to seek a specified value. Because policymakers typically look at a variety of indicators, they often observe conflicting signals. Moreover, different policymakers give different weights to different indicators. Thus, it is often difficult to predict how a group of policymakers will react to substantial changes in indicator values. • What Is P*? Simply put, P" is the eventual price level implied by the current level of the M2 monetary aggregate. It is calculated as p* = (M2 x V*)/Q*, where V* is an estimate of the long-run value of the GNP velocity of M2-the mean value from 1955:Q I to I988:Q4-and Q* is a Federal Reserve Board staff measure of potential output. Recent advances in understanding long-term statistical relationships indicate that P" AlPH1811 HOHV3S3H of reprinted materials to the editor. ISSN 0428·1276 Monetary indicators can help policymakers to evaluate the likely success or failure of policy instrument settings. The recently unveiled P-Star indicator can be useful as an indicator of potential inflation and, more broadly, as a method of assessing the Federal Reserve's long-term goal of price stability. and the current price level probably share a common trend. The indicator property, of P" is revealed in figure I. The vertical dotted lines denote the quarters when the current price level (implicit price deflator) and P" cross (top panel). Periods after which P" begins to persistently exceed the current price level are ultimately characterized by rising inflation (bottom panel) . Conversely, periods after which P" begins to persistently remain below the current price level are followed by periods of disinflation. There is a noteworthy variation, however, in the lag between the time the two series cross and the point when inflation changes direction.
@FedFRASER