Price-Level Targeting vs Inflation Targeting

Central banks choose between two broad frameworks for controlling inflation. With inflation targeting, the bank aims for a constant rate—say, 2% per year—and treats past misses as water under the bridge. With price-level targeting, the bank commits to a rising path for the overall price level and will raise or lower inflation today to correct for deviations from that path, undoing yesterday’s mistakes.

The Inflation Targeting Framework

Since the early 1990s, most major central banks have adopted inflation targeting—a quantified commitment to keep inflation within a narrow band or centered on a point target, usually 2% annually in developed economies.

The logic is intuitive. A stable inflation rate reduces uncertainty about the future value of money. Businesses can plan price changes more accurately. Workers and lenders can set wages and interest rates without second-guessing the erosion of purchasing power. The central bank announces its target, adjusts interest rates to hit it, and holds itself accountable.

Inflation targeting is backward-looking in a crucial sense: once a miss occurs, it is accepted and left behind. If the Federal Reserve aims for 2% inflation and delivers 4% one year, the response is not to engineer deflation the following year to bring the cumulative price level back in line. Instead, the Fed says: “We missed. Going forward, we will do better.” The 2% target resets each period.

This approach has a significant advantage: it is relatively easy to explain and monitor. Inflation either hits the target band or it doesn’t. It is also more flexible; if a shock (oil spike, financial crisis) forces inflation temporarily higher or lower, the central bank is not forced into a dramatic policy reversal.

Price-Level Targeting: An Alternative

Price-level targeting is a different animal. Instead of aiming for a constant inflation rate, the central bank targets a path for the overall price level—say, 2% growth per year compounded, implying an upward-sloping trend.

The crucial difference: if the price level falls below this path due to past deflation or undershooting, the central bank commits to inflation rates above 2% to bring the price level back to trend. Conversely, if it overshot in the past, the bank tolerates a period of low inflation or even mild deflation to pull the price level back down.

In plain terms, price-level targeting forces the central bank to correct its mistakes. Miss on the low side in year one? Make it up in year two or three. This built-in make-up mechanism is the defining feature.

Why the Difference Matters

The distinction has real consequences for households, businesses, and financial markets.

For expectations and credibility: A price-level target is self-reinforcing. If households and businesses believe the central bank will eventually correct any deflation, they won’t panic and hoard cash when prices temporarily fall. The very credibility of the target reduces deflationary risk. Inflation targeting, by contrast, offers no such promise. A string of low inflation or deflation can destabilize expectations and create a deflationary spiral that inflation targeting alone may struggle to reverse.

For savers and borrowers: If you lend money for 5 years under inflation targeting at a nominal rate of 4% (aiming for 2% inflation), and the central bank undershoots, you benefit unexpectedly. But the borrower suffers. Under price-level targeting, both parties expect some mean reversion: if inflation undershoots, future inflation will be higher, reducing the real burden on the borrower. This symmetry can stabilize long-term contracts.

For households: When the central bank misses low on inflation (deflation), the real value of wages and debt increases. Workers lose purchasing power; borrowers owe more in real terms. A price-level-targeting regime that commits to future make-up inflation limits this damage.

A Worked Example

Suppose a central bank targets a 2% annual price-level growth (compounded), starting at an index of 100 in year zero.

In year 1, inflation undershoots and the price level lags. Under inflation targeting, the central bank would say “2% is our target going forward” and ignore the year-1 miss. The target resets to 102, then 104, and so on, with the year-1 shortfall never recovered.

Under price-level targeting, the central bank commits to raising inflation above 2% in years 2 and 3 to claw back the lost ground. This creates pressure for the central bank to deliver 3% or higher, making up the gap.

Trade-offs and Criticisms

Price-level targeting is more credible and more symmetrical, but it comes with downsides:

1. Policy rigidity: The central bank is locked into a mechanical correction path. If real economic conditions change, the framework offers less flexibility. The bank cannot easily abandon the commitment without destroying credibility.

2. Commitment difficulty: It requires stronger institutional commitment than inflation targeting. Politicians and the public must accept that the central bank will tolerate above-target inflation to correct past misses—a hard sell when prices are rising.

3. Communication: Price-level paths are harder to explain than inflation rates. Surveys show most households understand “keep inflation at 2%” more readily than “maintain a 2% annual growth path for the price level.”

Current Practice

In practice, nearly all central banks use inflation targeting or variants of it. The European Central Bank, Federal Reserve, Bank of England, and Bank of Japan all frame their mandates in inflation-rate terms. Price-level targeting remains mostly theoretical, though the Bank of Canada and Reserve Bank of New Zealand have examined it, and some economists have proposed it as a way to combat the zero lower bound problem (the inability to push nominal rates below zero).

During the post-2008 period of very low inflation and deflation risk, some academics argued that a switch to price-level targeting would have prevented years of undershooting and anchored expectations more firmly.

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