But it only works if people understand the difference between an inflation target and price-level path target, and expect temporarily higher inflation with a price-level path target following a negative shock. And this experiment was designed to see whether people could figure it out.

The strength of automatic stabilisers will matter even more if you believe that the Zero Lower Bound on nominal interest rates may be a binding constraint on the Bank of Canada.

Shocks hit the economy, and the Bank of Canada responds to those shocks to try to keep Aggregate Demand growing steadily despite those shocks. But there are lags, and the Bank of Canada does not have a crystal ball, so it will always fail. But the amount by which it fails depends on the strength of the automatic stabiliser properties of the monetary policy regime -- what the Bank of Canada targets, and what instrument it uses. And there are reasons to believe that a price-level path target would make for a stronger automatic stabiliser than an inflation target. If a shock causes aggregate demand to fall, and the Bank is (unavoidably) slow to respond, so inflation falls temporarily, a price-level path target means that people will expect temporarily higher than normal inflation thereafter, which reduces the expected real interest rate for any given nominal interest rate, which partially offsets the negative shock to aggregate demand.

This (pdf) might be the most important controlled experiment economists have ever run. The results of this experiment have been influential in the Bank of Canada's decision (so far) to stick with targeting inflation rather than a price-level path. And making the right decision on that question could save many billions of dollars (trillions worldwide) in reducing the risk and magnitude of recessions. I had read about the results of that experiment (by Robert Amano, Jim Engle-Warnick, and Malik Shukayev) soon after it came out, but only now decided to take a closer look.

Participants were divided into an IT (Inflation Target control) group and a PLT (Price-level Target experimental) group. Both groups started out the same way: trying to forecast inflation in a simulated IT economy, where the best forecast was always 0% inflation regardless of actual past inflation. Then the PLT group were switched to a new simulated PLT economy, where the best forecast was always that the future price level would be a fixed number regardless of the past price level. The IT group continued in the same IT economy.

This design makes sense. Because the Bank of Canada had been targeting inflation for 20 years, and the policy choice is whether to stick with IT (control) or switch to PLT (experiment). We are not starting from scratch.

The researchers collected data on the subjects' inflation forecasts, then reported the results of a regression of those forecasts on the current price level and/or inflation.

The results were disappointing for the automatic stabiliser properties of price-level targeting. See columns 3 and 5 (1000 observations). Under rational expectations, the coefficient on the current price level should have been minus one, and the coefficient on current inflation should have been zero.

But the results were also disappointing for the automatic stabiliser properties of inflation targeting. See columns 2 and 4 (1060 observations). Under rational expectations, the coefficient on current inflation should have been zero.

If you are trying to decide between two policies, what matters is not how well or badly those two policies work, but which one works better or worse than the other. It's only the difference that matters.

Let's compare columns 4 and 5, so we are comparing like with like. Both columns show a "hot hand" effect, where people believe that inflation will have some degree of persistence (for a given price level), even when there is none. And that hot hand effect is only slightly bigger for the PLT group. But the IT group (rationally) ignore the current price level, and the PLT group (rationally) assign it a negative coefficient, but (irrationally) smaller than one.

That "hot hand" effect is a problem. Because it is an automatic de-stabiliser. But it's a problem for both IT and PLT.

Let's treat rational expectations IT as a benchmark, and arbitrarily assign it an automatic stabiliser strength of 0, then by my (very crude) calculation of simply adding the two coefficients together, rational expectations PLT would have an automatic stabiliser strength of minus 1 (a negative number is good). I would say that actual IT has an automatic stabiliser strength of plus 0.14 (bad, and worse than rational expectations IT), and actual PLT has an automatic stabliser strength of minus 0.38 (good, but not as good as rational expectations PLT). So there's a difference of 0.52 between those two policies, and not the difference of 1.0 that rational expectations would predict.

My reaction, taking the results of this experiment at face value? The automatic stabiliser effect of switching to price-level path targeting is only half as big as I hoped it would be, but I will take it, because half a loaf is better than none.

Should we take these results at face value? I don't know. Experimental economics is something I know very little about. But I do worry about this bit in the instructions given to participants:

"When you choose your bin, you will see an asterisk, that is, the character "*", located underneath the center of the bin containing the previous period's inflation. This character is placed on the screen to assist you with your forecast of inflation for the next period."

But being reminded of the previous period's inflation does not assist the participants' forecast of inflation. It is totally useless. In the IT economy, all past data is useless, and the best forecast is always 0% inflation. In the PLT economy, the only data that is useful is the previous period's price level. And if the only data you knew was the previous period's inflation rate, you would be assisted more by putting a minus sign on it before matching it up with a bin. It's a negative indicator.

Was the hot hand effect caused by the little "*" on the participants' computer screens, along with the instruction that it would "assist" them? I don't know.

The researchers then repeated the experiment with a very different and more complicated simulated economy. This time they used a New Keynesian DSGE model, setting the parameters to match the statistical moments in Canadian macro data. And this time the model had inflation inertia built in, so that high inflation one period would tend to be followed by high (but not quite as high) inflation the following period. And this inflation inertia was present for both IT and PLT. So it was rational to believe in hot hands. And this time, the participants got the strength of the hot hand effect roughly right. (The PLT group underestimated the strength of the price level effect, as before.)

Look, I know it's hard to explain to normal people (i.e. non-economists) the difference between the price level and the inflation rate. I know that because I teach Intro Macro. And if you tell people the current price level, and ask them to forecast the future price level, and future inflation rate, I'm not even sure their two answers will add up right. And what we call the Bank of Canada's communication strategy at this very basic level is very important. And that's why it made sense for anybody from the Bank, giving a talk on almost anything, to start out reciting the 2% catechism like the Holy Hand Grenade of Antioch: "2% shall be the number of our targeting, and the number of our targeting shall be 2%. We shall not target 1% unless we proceed to 2%; we shall not target 3% unless we proceed back down to 2%. 0% and 4% are right out."

Sometimes (though not always) it takes time for people to adjust to a new monetary regime. But if so, the time to start is now, before another recession comes along.

And an NGDP level path target would be better still. But you expected me to say that, didn't you.