What Is Price Level Targeting?
Price level targeting is a monetary policy framework that can be used to achieve price stability. LPrice level targeting is a technique in monetary policy, where the central bank increases or decreases the supply of money and credit in the economy in order to achieve a specified price level. Price level targeting can be contrasted to other possible targets that can be used to guide monetary policy such as inflation targeting, interest rate targeting, or nominal income targeting.
- Price level targeting is a way that central banks enact monetary policy by targeting a specific level of a price index, such as the CPI.
- Similar to forward-looking inflation targeting, price level targeting makes adjustments based on what has happened in the recent past.
- Price level targeting could be especially useful in a low interest rate environment when rates are already close to zero percent, since it can encourage more aggressive expansionary policy than a simple inflation target.
Understanding Price Level Targeting
Like inflation targeting, price level targeting establishes targets for a price index like the consumer price index (CPI). But, while inflation targeting specifies a growth rate in the price index, price level targeting specifies a target level for the index. In a sense inflation targeting is more forward looking in that it ignores past changes in the price level and looks only at the percentage increase in the current price level. By looking at the actual current price level, price level targeting implicitly includes past price changes and commits to reversing any deviations from past target.
For instance, if the price level fell below its target level in a given year, then the central bank would need to accelerate monetary expansion to meet its target in the next year in order to make up the larger gap between the actual current price level and its target. Under inflation rate targeting this would not be necessary.
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 the central bank overshoots its target price level one year, it might be forced to execute contractionary monetary policy to deliberately lower the price level the next year to meet its target.
For example, if a spike in oil prices caused a temporary increase in inflation, a price-level-targeting central bank could 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.
Price-level targeting is believed to increase short-term price volatility but to decrease long-run price variability. Over the long term, price level targeting is equivalent to inflation targeting that uses a stable long-run average inflation rate; price level targeting can simply target a path of successive price levels that follow a stable rate of increase. This can result in short-term volatility to correct for misses, but produces greater long-run price stability than constantly changing monetary policy to achieve a specific inflation rate relative to each new price level.
Price Level Targeting at the Zero Bound Interest Rate
Price level targeting has only seriously been attempted by the Swedish central bank, based on the theories of Swedish economist Knut Wicksell, after it abandoned the gold standard during the 1930’s. The Swedish strategy was intended as a way to temporarily replicate the gold standard, by targeting a constant, fixed price level, with neither inflation nor deflation, until some international metallic monetary standard could be re-established. This policy was blamed by later Swedish and Keynesian economists for aggravating unemployment in Sweden during this period.
However, with nominal interest rates close to the zero bound in many countries, price-targeting has again 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. In addition, 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.