Price level targeting

What Is Price level targeting?

Price level targeting is a monetary policy framework in which a central bank aims to maintain a specified path for the overall price level, rather than focusing solely on the rate of inflation. Unlike inflation targeting, which seeks to keep the inflation rate at a constant percentage, price level targeting commits the central bank to offset past deviations of the price level from its target path. If the price level falls below its target, the central bank would pursue policies to cause future inflation to temporarily rise above its long-term average to return to the predetermined path. Conversely, if the price level rises above its target, the central bank would aim for a period of below-average inflation to bring the price level back down. This approach is designed to provide greater long-term price stability and anchor public expectations about the future purchasing power of money.

History and Origin

The concept of targeting the price level has roots dating back to the early 20th century, with economists like Irving Fisher proposing systems to stabilize the purchasing power of money, particularly after the crisis of the gold standard following World War I. While inflation targeting became the dominant framework for many central banks starting in the 1990s, the idea of a price level target saw limited, though notable, historical application. Sweden, for example, experimented with price level targeting in the 1930s, specifically targeting the consumer price index.¹⁴,¹³ This period often stands as the sole historical instance of a central bank explicitly implementing such a policy.¹²

In more recent decades, particularly in the aftermath of the 2008 global financial crisis and subsequent periods of low interest rates and low inflation, interest in price level targeting has revived.¹¹ Economists and policymakers began to re-evaluate its merits, especially as a potential tool to address situations where nominal interest rates approach the effective lower bound.¹⁰,⁹ Discussions among Federal Reserve officials, for instance, have included consideration of a price level path target as an alternative strategy to traditional inflation targeting.⁸

Key Takeaways

• Price level targeting commits a central bank to return the overall price level to a predetermined path, compensating for past deviations.
• This approach aims to reduce long-term uncertainty about the future purchasing power of money.
• Unlike inflation targeting, which "lets bygones be bygones," price level targeting is "history-dependent," requiring corrective action for past price level misses.
• It is considered potentially advantageous in periods of low interest rates or deflation as it encourages expectations of higher future inflation to stimulate aggregate demand.
• Despite theoretical advantages, price level targeting has seen very limited practical adoption by central banks.

Interpreting Price level targeting

Interpreting price level targeting hinges on understanding its commitment to a path for prices. Under this framework, a central bank doesn't just aim for a specific inflation rate each year; it aims for a specific cumulative price level over time. If the actual price level deviates from this target path—for instance, due to an unexpected period of low inflation or even deflation—the central bank is obligated to implement policies that would lead to a period of higher-than-average inflation until the price level is back on its intended trajectory. This commitment is intended to firmly anchor long-run inflation expectations, making the ultimate future price level more predictable for economic agents. This predictability can influence borrowing and lending decisions and foster greater economic stability.

Hypothetical Example

Consider a hypothetical country, "Econoland," where the central bank adopts price level targeting with an aim for the price level to increase by a consistent 2% per year from a base index of 100.

• Year 1: The target price level is 102. Due to a severe economic downturn, the actual price level only reaches 100.5, falling short of the target.
• Year 2: Under a price level targeting regime, the central bank does not simply aim for 2% inflation from 100.5. Instead, it must account for the shortfall. The original target path implies a price level of 104.04 (102 * 1.02) for Year 2. Since the actual price level in Year 1 was 100.5, the central bank would now aim for an inflation rate significantly higher than 2% for Year 2 to try and reach 104.04. This might involve setting lower short-term interest rates and other accommodative policies to stimulate spending and push prices higher.
• The central bank's communication would emphasize its commitment to reaching the original path, signaling to businesses and consumers that future inflation will likely be higher than normal to "make up" for the past undershoot. This expectation of higher future inflation helps to lower real interest rates and stimulate investment, narrowing the output gap.

Practical Applications

While not widely adopted, price level targeting has been a subject of significant academic and policy discussion, especially in scenarios where conventional monetary policy tools face limitations.

One key area of application discussed is its potential utility when a central bank's policy rate approaches the "zero lower bound." In such an environment, the ability to stimulate the economy through further interest rate cuts is constrained. A credible price level target, by promising future above-average inflation if current inflation is too low, could lower real interest rates by raising expected inflation, thereby providing additional stimulus to the economy. This is seen as a way to enhance the effectiveness of monetary policy during periods of economic weakness.

Fu⁷rthermore, some proponents argue that price level targeting could lead to greater stability in economic variables like Gross Domestic Product (GDP) and employment over the long run, provided agents form rational expectations and prices are sticky. Thi⁶s could also be a theoretical underpinning for policies like quantitative easing and forward guidance, as these are ways central banks try to influence future expectations.

The Banque de France has also examined price level targeting, noting its potential to make unconventional policies, such as keeping interest rates low after a recession, a more conventional and expected part of a central bank's framework.

##⁵ Limitations and Criticisms

Despite its theoretical advantages, price level targeting faces several significant limitations and criticisms that have prevented its widespread adoption.

One major concern is the potential for increased short-term inflation volatility. If a central bank misses its price level target, the policy requires it to deliberately engineer periods of either higher or lower inflation to correct the deviation. This could lead to larger swings in the inflation rate from year to year, potentially making economic planning more difficult for businesses and households. Critics also argue that this "make-up" aspect of the policy could be politically challenging for a central bank to implement, especially if it requires a period of deliberately high inflation following an undershoot or a period of potential deflation following an overshoot.

An⁴other criticism relates to communication and public understanding. Central banks have invested decades in establishing the credibility of inflation targets. Shifting to a more complex price level target, which implies varying short-term inflation rates, might confuse the public and potentially undermine the central bank's credibility. Som³e argue that the public might perceive periods of above-target inflation as a permanent shift rather than a temporary correction, leading to unanchored expectations.

Fu²rthermore, the effectiveness of price level targeting relies heavily on the assumption that economic agents form "rational expectations" about future policy and prices, and that wages and prices are "sticky," meaning they adjust slowly. If these assumptions do not hold, the expected benefits, such as lower real interest rates in a downturn, may not materialize. The policy's response to supply shocks is also a point of contention, as a negative supply shock (e.g., a spike in oil prices) that raises the price level would require the central bank to tighten monetary policy, even if the economy is already weak, which could be procyclical. The¹ Phillips Curve relationship, which links inflation and unemployment, becomes particularly relevant here, as efforts to restore the price level could have implications for the unemployment rate.

Price level targeting vs. Inflation targeting

Price level targeting and inflation targeting are both frameworks for monetary policy aimed at achieving price stability, but they differ fundamentally in how they treat past deviations from their targets.

The key distinction lies in the concept of "base drift." Under inflation targeting, if inflation is unexpectedly high for a period, the central bank aims to return inflation to its target, but the higher price level reached during the surprise period becomes the new base—the "bygones are bygones" principle. Consequently, the long-run price level can drift significantly from where it would have been had inflation always hit its target. With price level targeting, any deviation from the target path must eventually be corrected, eliminating base drift and ensuring the price level returns to its specific growth trajectory over time. This makes the long-term purchasing power of money more predictable under price level targeting.

FAQs

What is the main advantage of price level targeting?

The main advantage is increased long-term certainty about the future price stability and the purchasing power of money. By committing to return to a specific price path, it helps anchor long-run inflation expectations, which can be particularly beneficial during periods where nominal interest rates are near zero.

Has any country successfully implemented price level targeting?

Sweden implemented a form of price level targeting in the 1930s. While discussions have revived, especially among central bankers and economists, no major central bank currently explicitly uses price level targeting as its primary monetary policy framework.

How does price level targeting respond to unexpected economic shocks?

If an unexpected economic shock causes the price level to deviate from its target path, a price level targeting central bank is committed to adjusting policy to bring the price level back to that path. This means a period of below-target inflation would be followed by a period of above-target inflation (and vice-versa) until the cumulative deviation is corrected. This mechanism is intended to influence expectations and stabilize the economy.

Is price level targeting the same as nominal GDP targeting?

No, price level targeting is not the same as nominal GDP targeting. Price level targeting focuses exclusively on the overall level of prices. Nominal GDP targeting, on the other hand, targets the total value of goods and services produced in an economy at current prices (nominal GDP), which includes both the price level and the real output. While both are "level" targets, nominal GDP targeting implicitly accounts for both inflation and real economic growth.