What is Price Level Targeting

Price level targeting is a monetary policy framework that can be used to achieve price stability. Like inflation targeting, price level targeting establishes targets for a price index like the consumer price index. But while inflation targeting is forward looking, price-level targeting commits to reversing any temporary deviations from the target rate of inflation. If inflation fell below 2% for a time, the central bank would compensate by aiming for inflation above 2% until average inflation over the whole period had returned to 2%.

BREAKING DOWN Price Level Targeting

Price-level targeting is, theoretically, more effective than inflation targeting because the target is more precise. But it is riskier, given the consequences of missing the target. If inflation is unexpectedly high one year, aggregate prices would have to be lowered the next year.

For example, if a spike in oil prices caused a temporary increase in inflation, a price-level-targeting central bank would have to tighten monetary policy, even in an economic downturn, in contrast to an inflation-targeting central bank, which might look past the temporary increase in inflation. Naturally, this would be politically fraught.

This tendency for price-level targeting to increase inflation volatility and amplify the economic cycle, is why no central bank has tried implementing price-level targeting since Sweden experimented with it in the 1930s.

Price Level Targeting at the Zero Bound Interest Rate

However, with nominal interest rates close to the zero bound in many countries, price-targeting has become a topical issue. At the zero bound, a negative demand shock leads to a rise in real interest rates under inflation targeting — assuming inflation expectations remain anchored. Worse, if households and firms think monetary policy has become impotent, and their inflation expectations fall, real interest rates will rise even further, increasing the risk of a recession.

In contrast, price-targeting creates a different dynamic for inflation expectations when an economy is hit by a negative demand shock. A credible price-level target of 2% inflation would create the expectation that inflation would rise above 2%, because everyone would know that the central banks was committed to making up the shortfall. This would increase upward pressure on prices which would lower real interest rates and stimulate aggregate demand.

Whether price-level targeting leads to higher GDP growth in a deflationary environment than inflation targeting very much depends on whether or not the world conforms to the New Keynesian view that prices and wages are sticky, meaning they adjust slowly to short-term economic fluctuations, and that people form their inflation expectations rationally.