Academic journal article Economic Review (Kansas City, MO)

Beyond Inflation Targeting: Should Central Banks Target the Price Level?

Academic journal article Economic Review (Kansas City, MO)

Beyond Inflation Targeting: Should Central Banks Target the Price Level?

Article excerpt

Over the last two decades, many central banks have adopted formal inflation targets to guide the conduct of monetary policy. During this period, inflation has come down in many countries and been relatively stable by historical standards. This favorable performance to date, however, has not stopped economists and policymakers from considering other approaches to the conduct of policy. One idea that has gained considerable attention is price-level targeting. For example, the Bank of Canada is actively researching the use of price-level targets as an alternative to inflation targets in anticipation of its next policy agreement with the Government, set for 2011. Under a price-level target, a central bank would adjust its policy instrument-typically a short-term interest rate--in an effort to achieve a pre-announced level of a particular price index over the medium term. In contrast, under an inflation target, a central bank tries to achieve a pre-announced rate of inflation--that is, the change in the price level--over the medium term.

Price-level targeting offers a number of potential benefits over inflation targeting. While inflation targets have helped stabilize inflation, the future level of prices remains uncertain. Price-level targets would by definition remove much of this uncertainty. Price-level targeting also has the advantage of potentially generating greater stability of both output and inflation. Particularly in the current low-inflation environment, where nominal policy rates have fallen near zero, price-level targeting may help support expectations of a positive inflation rate. These inflation expectations, in turn, would keep real interest rates negative, thereby stimulating interest-sensitive spending and contributing to economic recovery.

While price-level targeting offers a number of potential benefits relative to inflation targeting, the benefits may be relatively small and uncertain. In addition, price-level targeting is untested in practice (except for Sweden in the 1930s) and would present challenges for policymakers in communicating with the public regarding the objectives and direction of policy over the medium run. As a result, price-level targeting will not likely be adopted by central bankers without considerable further research or a dramatic deterioration in economic performance that leads policymakers to fundamentally reconsider how they conduct monetary policy.

The first section of the article defines price-level targeting. The second section identifies how a price-level target can, in theory, improve economic performance relative to an inflation target. The third section provides a number of reasons why policymakers may be reluctant to move to price-level targeting.

I. WHAT IS PRICE-LEVEL TARGETING?

A primary goal of central banking is "price stability." For example, the Federal Reserve Act defines the goals of U.S. monetary policy as "maximum employment, stable prices, and moderate long-term interest rates." Taken literally, price stability is a constant price level. But, in practice, no modern central bank pursues literal price stability as a goal. Instead, central bankers have interpreted the goal of price stability more broadly. Former Federal Reserve Chairmen Paul Volcker and Alan Greenspan have defined price stability as a macroeconomic environment in which inflation is not a factor in the decisions of consumers and businesses. Other central bankers have interpreted price stability as a "low and stable" rate of inflation. (1) And, at many central banks, price stability is defined explicitly as a numerical target for inflation in a particular price index. For example, the Bank of England defines price stability by an inflation target set by the Government of 2 percent annual inflation in the consumer price index.

While there is agreement that inflation is costly and should therefore be minimized, for a number of reasons policymakers nevertheless aim for an inflation rate above zero. …

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