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.

RELATED TERMS
  1. Inflation Targeting

    Inflation targeting is a central banking policy that revolves ...
  2. Inflation Trade

    An inflation trade is an investing scheme or trading method that ...
  3. Inflation

    Inflation is the rate at which prices for goods and services ...
  4. Inflation Protected

    Inflation protected refers to types of investments that provide ...
  5. Headline Inflation

    Headline inflation is the raw inflation figure reported through ...
  6. Zero Coupon Inflation Swap

    A zero coupon inflation swap is an exchange of cash flows that ...
Related Articles
  1. Insights

    Inflation's Impact on Stock Returns

    Learn about the impact inflation can have on stock returns. Find information on what types of stocks perform during times of high inflation or low inflation.
  2. Insights

    A Primer On Inflation

    Inflation has a negative connotation, but is it all bad or does it offer some tangible benefits?
  3. Trading

    Coping With Inflation Risk

    Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.
  4. Insights

    The Importance Of Inflation And GDP

    Learn the underlying theories behind these concepts and what they can mean for your portfolio.
  5. Trading

    How CPI Affects the Dollar Against Other Currencies

    The Consumer Price Index is a broad measure of inflation, and inflation can have a dramatic impact on a currency's value against rival currencies.
  6. Personal Finance

    Fight Back Against Inflation

    Inflation is often a consequence of economic recovery. Here's how you can protect your financial portfolio.
  7. Retirement

    Combating Retirement's Silent Killer: Inflation

    Inflation can devour a once secure nest egg. Learn how to protect yours.
  8. Financial Advisor

    Why Inflation Feels Higher Than the Fed's Target Rate

    Follow the monthly readings on core PCE inflation in the Personal Income and Outlays reports to understand the Federal Reserve's inflation assessments.
  9. Insights

    Central Banks Not Equipped for Recession: Bank of America

    As inflation rates remain benign central banks are in no position to handle another recession.
RELATED FAQS
  1. What is inflation and how should it affect my investing?

    The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss ... Read Answer >>
  2. How Can Inflation Be Good for the Economy?

    Find out why some economists and public policy makers believe that inflation is a good, or even necessary, phenomenon to ... Read Answer >>
  3. Why Are P/E Ratios Higher When Inflation Is Low?

    P/E ratios are generally higher during times of low inflation, but why is this the case? Read Answer >>
  4. What is the relationship between inflation and interest rates?

    As interest rates are lowered, more people are able to borrow more money, causing the economy to grow and inflation to increase. ... Read Answer >>
  5. What does the current cost of living compare to 20 years ago?

    Find out how inflation has affected the dollar since 1998, and how the cost of living has changed above and beyond what can ... Read Answer >>
Hot Definitions
  1. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  2. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  3. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  4. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  5. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  6. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
Trading Center