The Economist wants inflation targeting to include asset prices

The leader to The Economist's article on the Fed and inflation this week ends with the following:

During the past century, every monetary rule has eventually broken down: the gold standard, the Bretton Woods system of fixed exchange rates, and monetary targeting. Now it seems that strict inflation targeting may not be a panacea either. It would be foolish for the Fed to sign up for crude inflation targeting just as it goes out of fashion.

Fair enough. Inflation targeting has pros and cons, and I haven't been convinced yet that the pros outweigh the cons. In a perfect world, it would be easier to convince me, but... I don't have to finish that sentence, do I? That paragraph could be the end of a nice article explaining the pros and cons of rules vs. discretion and the Fed's dual (and somewhat contradictory) objectives.

But it wasn't. For instance, they say,

Some central bankers in Britain, continental Europe, Australia and New Zealand have said publicly that monetary policy needs to take more account of asset prices and that sometimes interest rates may need to rise by more than if the sole objective were to keep consumer-price inflation within target.

In a recent article, Otmar Issing, the chief economist of the European Central Bank (ECB), threw down the gauntlet to the Fed. He argued that it is hard, but not impossible, to identify when asset prices are overshooting; there are benchmarks against which valuations can be judged. If prices look frothy, central banks should signal their concern. And they should certainly avoid contributing to “unsustainable collective euphoria”. Central banks should also look out for the surge in money and credit which often accompanies a bubble.

The accompanying article says much the same thing.

Back in 2001, the president of the St. Louis Fed, William Poole, gave a talk at my campus that makes a number of important points on this issue. There's a lot of information in asset prices, but the Fed should not target them directly. One of Poole's more salient points is this,

A widely known result from control theory states that, with one instrument, the policymaker can at best achieve one policy objective. That objective, in my view, ought to be a low and stable rate of inflation. As a matter of logic, therefore, pursuing a separate stock market objective means compromises of some sort on the inflation objective. Clearly, targeting the stock market might come at a high price. Once the Federal Reserve compromises on its price stability goal, inflation and inflation expectations build up. Experience shows that inflation expectations are persistent, and inflation fighting tends to entail recessions. Because permitting the economy to run off track has negative consequences for the stock market, any effort to target the stock market is likely to be self-defeating.

Or, to extend that point to the present discussion, what do you do when asset prices and the CPI diverge, as The Economist suggests is the case, this time for housing values instead of the stock market? And that brings up an even more troubling question of what do when the stock market is flat, the CPI rising moderately, and housing going through the roof?

I don't know either. I suppose you can use the usual array of blunt policy instruments, but that means that sometimes the CPI growth could go dangerously low (or negative). Again, The Economist:

Given the elusiveness of a perfect price index, central banks should keep using conventional, narrow inflation targets, but be prepared to undershoot them temporarily if house or share prices soar.

Not a good idea. Brad DeLong agrees. Seems like they are asking the Fed to target relative prices AND nominal prices. I don't think they have enough policy instruments to do that without there being some rather serious consequences.