New thoughts on Manipulating expectations to avoid Deflation

"Excerpt"

Price Expectations
Second, and most relevant, is the idea that targeting the price level will help central banks deal with deflation. If consumers and companies expect the CPI will go from 100 today to 110.4 in five years, they will be less likely to delay purchases in the hope that costs will drop, potentially breaking the deflationary spiral of falling demand and prices.

“By providing households and businesses with greater certainty about the price level well into the future,” such targeting “might reduce the risks associated with entering into long-term financial obligations,” the Bank of Canada said in the 2006 paper.

More confidence about price movements would “absolutely” help the economy, said Larry O’Brien, founder of Ottawa-based technology staffing company Calian Technologies Ltd. and a former mayor of the Canadian capital.

Workers would be discouraged from seeking “inflationary agreements” in labor talks, and people would have more guidance when they “don’t know if we’re getting inflation or deflation,” O’Brien said.




BLOOMBERG
Fed Avoiding Deflation May Depend on Canadian CPI Experiments
By Greg Quinn

Read whole thing -http://noir.bloomberg.com/apps/news?pid=20601087&sid=awmnIhmkEy2I&pos=7

Dec. 6 (Bloomberg) -- Montreal undergraduates may help reshape the Bank of Canada’s monetary policy and give Federal Reserve Chairman Ben S. Bernanke and Bank of Japan Governor Masaaki Shirakawa clues about how to ward off deflation.
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The experiments will help Canada decide if it should switch from inflation targeting to price-level targeting in 2012 and may help the bank better communicate its policies to the public, Boivin said. The test results also might benefit Fed policy makers, who discussed price-level targets on Oct. 15 and voted Nov. 3 to inject another $600 billion of reserves into the banking system to avoid deflation -- a widespread drop in prices that has plagued Japan for more than a decade.

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Broader Agenda
“Central banks need to know more about how expectations are formed, and so we see that as part of a much broader agenda,” Boivin said in an interview at the Bank of Canada’s Ottawa headquarters in the room where he, Governor Mark Carney and four other policy makers decide on interest rates, including a decision tomorrow that’s scheduled for 9 a.m. New York time.

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Canada led the Group of Seven by adopting an inflation target in 1991, a policy about two dozen central banks now use, including the Bank of England and the European Central Bank. Canada may again be at the forefront if it switches next year to targeting the consumer price-index level after the expiration of its five-year agreement with the government to target a 2 percent inflation rate.

The main difference between the two systems is how officials take past inflation into account when making decisions about interest rates. With inflation targeting, “bygones are bygones,” the Bank of Canada said in a 2006 paper it published the last time the agreement was renewed. Policy makers who target 2 percent inflation, like Canada’s, will always adjust interest rates aiming to bring about 2 percent inflation, no matter how badly they missed the target in the past.

Offset Misses
By contrast, targeting specific CPI levels obliges the bank to adjust the pace of price changes, setting interest rates to engineer quicker or slower inflation to offset past misses.

As long as inflation behaves as the central bank wants, there’s no practical difference between the two policies. Officials who successfully target 2 percent annual inflation for five years will make the same decisions as those who want the CPI to go from 100 to 110.4 in the same period. It’s when inflation is persistently off course, as has been the case in Japan, that the implications of the difference become clearer.

First, the magnitude of interest-rate moves may differ. When inflation is persistently slower than a price-level targeting central bank wants, it may bring CPI back to the desired path by leaving interest rates lower for a longer period of time than it would if it targeted inflation.

Price Expectations
Second, and most relevant, is the idea that targeting the price level will help central banks deal with deflation. If consumers and companies expect the CPI will go from 100 today to 110.4 in five years, they will be less likely to delay purchases in the hope that costs will drop, potentially breaking the deflationary spiral of falling demand and prices.

“By providing households and businesses with greater certainty about the price level well into the future,” such targeting “might reduce the risks associated with entering into long-term financial obligations,” the Bank of Canada said in the 2006 paper.

More confidence about price movements would “absolutely” help the economy, said Larry O’Brien, founder of Ottawa-based technology staffing company Calian Technologies Ltd. and a former mayor of the Canadian capital.

Workers would be discouraged from seeking “inflationary agreements” in labor talks, and people would have more guidance when they “don’t know if we’re getting inflation or deflation,” O’Brien said.