Flexible Price-Level Targeting vs Inflation Targeting

The difference between flexible price-level targeting and inflation targeting comes down to how a central bank treats the past. Inflation targeting lets bygones be bygones—if inflation overshot last year, you start fresh. Price-level targeting never forgets: it must make up any shortfall later, pushing inflation above the target temporarily to restore the cumulative price path.

How the Two Frameworks Differ

Inflation targeting is the standard. A central bank commits to holding the inflation rate—say, 2 percent per year—in a given horizon (often a year or two ahead). If inflation runs 3.5 percent one year, the next year the bank aims for 2 percent again. The past overshoot is not reversed; it is simply accepted as history.

Price-level targeting inverts this logic. The bank targets the total price level along a rising path. If prices should follow a 2-percent annual trend line, the path should roughly double every 35 years. If inflation falls short one year and prices undershoot the path, the bank must permit higher inflation later to climb back to trend. Equally, if inflation overshoots, the bank tolerates below-target inflation to restore the path.

The practical difference is stark. Under inflation targeting, a decade of 1-percent inflation followed by a decade of 3-percent inflation looks fine: the average is 2 percent. Under price-level targeting, that same history is a problem. The first decade left prices 10 percent below trend; the second decade must compensate, requiring inflation above 2 percent until the gap closes.

Makeup Inflation and Expectations

The mechanism that makes price-level targeting work is makeup inflation—the central bank deliberately tolerates a period of above-target inflation to reverse a past undershooting. This sounds odd, but it serves a purpose: it tells households and firms that the central bank means it.

Under inflation targeting, a household might infer: “If inflation comes in at 1 percent, the central bank will keep it at 2 percent going forward. I can lock in price changes knowing that.” But over decades, if the central bank misses low repeatedly and never makes it up, prices drift permanently below the trend the central bank once implied. Households begin to doubt the credibility of the 2-percent target because they see the central bank tolerating long stretches of underperformance.

Under price-level targeting, the household observes: “If inflation came in at 1 percent last year, the central bank is now aiming for 3 percent this year to make it up.” This resets expectations. The central bank is showing it will not allow past shortfalls to become permanent, reinforcing the idea that the long-run price path is stable and knowable.

Why Most Central Banks Use Inflation Targeting

Despite the logical appeal of price-level targeting, nearly all major central banks—the Federal Reserve, the European Central Bank, the Bank of England—practice inflation targeting. Why?

First, the near-term trade-off is uncomfortable. If deflation or very low inflation has just ended (as in 2010–2015), switching to price-level targeting requires explicitly promising a period of above-target inflation. This is politically difficult. A central bank aiming for 2 percent is easier to defend than one saying, “We’re targeting 3.5 percent for the next two years.” Lawmakers and the public perceive the latter as failure.

Second, the assumption of “level” is fragile. In practice, there is no single true price level. Different measures exist: headline inflation, core inflation, inflation weighted by spending patterns, regional inflation. If a central bank commits to a cumulative price path and then economists publish a revised inflation measure, the bank must decide whether it has overshot or undershot. This ambiguity undermines the credibility that makeup inflation is supposed to provide.

Third, inflation targeting works well enough in practice, so long as the central bank is credible. The Federal Reserve, for example, kept inflation expectations firmly anchored around 2 percent for three decades (the “Great Moderation,” 1990–2020), even though actual inflation varied. This suggests that a clear, constant communication of a 2-percent target, paired with a track record of returning inflation to that target, can stabilize expectations without requiring makeup inflation.

The Underappreciation of the Past-Path Problem

That said, some economists—particularly those who studied the post-2008 period—argue that inflation targeting carried a hidden cost. From 2010 to 2020, inflation in the United States, Japan, and the eurozone ran consistently below target. Under strict price-level targeting, this shortfall would have created a mandate for makeup inflation in the mid-2020s, possibly preventing the surprise inflation spike of 2021–2023.

Instead, inflation targeting treated each year independently. Central banks did not feel obliged to make up the lost years. When demand surged in 2021 (due to stimulus and supply-chain disruptions), inflation rose sharply, but the central banks were not consciously running above target to restore a long-run path—they were simply responding to new shocks with standard tools.

Critics suggest that this contributed to the inflation surprise: if the public and markets had understood that below-target inflation years created a future obligation to overshoot, they might have been more prepared for, or even protective against, the 2021–2023 spike.

Expectations Anchoring in Practice

The core insight is that price-level targeting forces the central bank to be predictable over decades, while inflation targeting allows century-long drift as long as no single period overheats. If households truly care about long-run purchasing power—and they do—then price-level targeting is the more honest framework.

However, achieving this requires the central bank to articulate the target clearly, to stick to it through political pressure, and to resist changing the definition of the price level whenever a new shock hits. In reality, most central banks have found it easier to keep the goal simple: “inflation stays around 2 percent going forward,” updated on a rolling basis.

Recent inflation episodes have revived academic interest in price-level targeting. If central banks move toward it, the main shift for borrowers and savers would be greater predictability of long-run nominal price paths, at the cost of accepting higher inflation volatility in any given year.

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