Missed Inflation Targets and the Case for Price-Level Targeting

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February 5, 2014 – While the Bank of Canada has quietly shelved consideration of moving to price-level targeting as a basis for monetary policy, the merits of this approach remain strong, according to a report released today by the C.D. Howe Institute. In “Price-Level Targeting: A Post-Mortem?” author Steve Ambler finds price-level targeting has convincing advantages over inflation-targeting, especially as a tool for avoiding the worst consequences of economic downturns.

Given that many central banks have expressed concern over deflation and missed targets, a second look at price targeting is due. “Price-level targeting is an alternative that offers potential advantages over inflation targeting,” said Steve Ambler, the David Dodge Chair in Monetary Policy at the Institute. “It can lead to greater stability both of inflation and of output. In troubled economic times such as the recession in the aftermath of the 2008 financial crisis, price-level targeting can increase the effectiveness of monetary policy, especially when the central bank’s policy rate is stuck at its lower bound of zero,” he said.

In the report, Ambler explains the main differences between conventional inflation-targeting (IT) and price-level targeting (PT) as follows:  Inflation targeting   involves setting an inflation rate target, using the short-term nominal interest rate as the primary tool for achieving the target. Under IT, unexpected deviations from the inflation target are forgotten. The central bank merely tries to bring inflation back to its targeted rate, regardless of whether it had overshot or undershot that target in the past. For this reason, unexpected changes in inflation have a permanent effect on the price level.

With the kind of persistently low inflation that is bedeviling central banks in major western economies, price-level targeting would have advantages. It involves setting a pre-announced path for the price level and using the same policy instrument, the short-term nominal interest rate, to affect prices. This means that PT involves offsetting the impact of inflation shocks on the price level. Under PT, inflation shocks can have only a temporary effect on the price level.

Conversely, after an unexpected increase in inflation,  the central bank, under PT,  would commit to reducing inflation below the target rate in the medium term in order to bring the price level back to its target. As a result, future inflation under PT is expected to be lower than under IT. Knowing this, firms that fix their prices for several periods would not raise them as much since they know that the general price level will not be as high in the medium run.

“This is the ‘expectational bonus’ under PT that can lead to lower volatility in prices and output,” explained Ambler.  “Because expected future inflation is lower under PT, current inflation is lower as a result.”

Although several central banks have been coping with the aftershocks of the 2008 financial crisis for prolonged periods, none has adopted price-level targeting, he notes. Ambler reviews some of the reasons for this in the Canadian and American contexts. The Fed prefers to exercise discretion, he finds, and inflation targeting allows central banks to ignore past inflation shocks and engage in fine-tuning of the business cycle. The Bank of Canada shares the Fed’s predilection for discretion.

“The main reason that central banks have not experimented with PT is that they are too wedded to the ability to exercise discretion in the conduct of monetary policy,” said Ambler. “However, rumors of its death are surely premature.”

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