Price Level Targeting

In price level targeting, a central bank commits to maintaining the price level on a specific upward-sloping path—for example, allowing 2% annual growth from a baseline—and explicitly promises to offset any shortfall from that path through future overshoots. Unlike inflation targeting, which permits permanent drift in the price level, price level targeting anchors an absolute price path, eliminating long-run price-level uncertainty and strengthening deflation protection during downturns.

Price level versus inflation rate targeting: the key difference

Under conventional inflation-targeting, the central bank commits to keeping the rate of price change at (typically) 2% per year. But this is a forward-looking commitment only. If the price level undershoots during a recession and deflation temporarily occurs, the central bank does not promise to make up the lost ground; it simply returns to targeting 2% growth going forward. This means the absolute price level drifts downward and never fully recovers.

Price level targeting, by contrast, is a commitment to an absolute path. If the baseline price level is 100 and the target is to reach 102 after one year (a 2% rise), the central bank must hit 102. If deflation causes prices to fall to 101, the central bank cannot simply restart from 101; it must overshoot future growth to return to the 102 path. This makeup accommodation is the defining feature—and the commitment device—of price level targeting.

Makeup accommodation and expectations anchoring

The makeup accommodation mechanism is theoretically powerful for anchoring expectations. Households and firms that believe the central bank will restore a price path, if it undershoots, have stronger confidence that deflation will not spiral out of control. During a severe recession, when deflation risk is highest, the credible promise to overshoot later can stabilise wages and pricing behaviour now, preventing the self-reinforcing downward cycle of falling prices, rising real debt burdens, and further cutbacks in spending.

In contrast, an inflation-targeting central bank can appear to accept permanent deflation-driven price-level losses, which erodes its inflation-fighting credibility during downturns. Price level targeting flips this: it is maximally credible in defending the lower bound, because overshooting is built into the commitment.

Implications during recessions and demand shocks

When aggregate demand collapses and deflation threatens, price level targeting mandates aggressive monetary monetary-policy accommodation. The central bank must not only return to the target growth path but also compensate for the shortfall—in effect, running temporarily looser policy to achieve makeup growth.

This contrasts sharply with inflation targeting, where the central bank might tighten during or after a downturn if inflation remains above a historical average, even if the economy is weak. Price level targeting removes this trap: monetary accommodation is automatic and credible because the makeup promise is explicit.

Long-run price-level certainty and contract design

Price level targeting eliminates long-run price-level uncertainty in a way inflation targeting does not. Under inflation targeting, if the central bank misses its 2% target by 1% for twenty years (delivering only 1% per year on average), the price level compounds 20% lower than expected. This matters for long-term real contracts, pensions indexed to prices, and macroeconomic planning.

Under price level targeting with a credible path, long-run price levels are predictable. This precision is valuable for long-duration investments, real-estate-investment-trust planning, and pension valuations. Firms can negotiate multi-year contracts with less inflation risk because the price path is anchored.

Risks of overshooting and credibility trade-offs

The main critique of price level targeting is that makeup accommodation can lead to temporary inflation overshoots—precisely what the central bank is trying to avoid. If a severe deflationary shock hits, the central bank must run loose enough policy to overshoot the target path in recovery. If the public does not fully believe the makeup commitment is temporary, inflation expectations could de-anchor upward, and nominal wage-setting behaviour could adjust, creating a self-fulfilling inflation spiral.

Most economists argue this risk is manageable if the central bank clearly communicates that the overshoot is temporary and that it will re-tighten once the path is restored. But the credibility burden is higher than under inflation targeting. A central bank that overshoots inflation risks being perceived as having capitulated to the political desire for loose money, rather than implementing a coherent long-term framework.

Comparison with nominal-gdp-targeting

Price level targeting and nominal-gdp-targeting are distinct but related. Price level targeting focuses solely on the price level (and ignores real output in the rule). Nominal-gdp-targeting targets the combined growth of output and prices, automatically tolerating higher inflation if real growth is weak, and vice versa.

During a negative supply shock (say, a spike in crude-oil prices), price level targeting insists the central bank keep the absolute price level anchored—which requires accepting lower real growth and employment. Nominal-gdp-targeting would automatically accommodate the inflation, allowing the price path to rise while output contracts, and the nominal GDP target is satisfied by the mix.

Price level targeting is thus more hawkish on inflation (in the sense of prioritising price stability), while nominal-gdp-targeting is more flexible and favours demand-side stabilisation.

Implementation challenges

Price level targeting is harder to implement in practice than inflation targeting because the central bank must measure and forecast the price level—and commit publicly to restoring it if undershooting occurs. This requires a long institutional memory: if a past undershoot is forgotten or revised away by data reweighting, the central bank’s credibility crumbles.

Additionally, the price-level concept itself is slippery: Which prices? Consumer prices, asset prices, wages? Different indices can diverge, especially during structural transitions (e.g., the shift from manufacturing to services). An inflation-targeting regime can dodge these questions by focusing on a single headline or core inflation measure. A price-level-targeting regime must specify the exact path and measurement, leaving less room for interpretation.

Limited real-world adoption

Most major central banks (the Federal Reserve, the European Central Bank, the Bank of England) formally target inflation rates, not price levels. Sweden’s Riksbank has experimented with price-level targeting elements in its communication, and some economists and central bankers have advocated for it during crisis periods—but no major central bank has formally switched to an explicit, unconditional price-level target across all monetary-policy decisions.

The adoption gap reflects both theoretical debate and practical concerns. Central bankers worry that communicating a price-level path and the makeup obligation is harder than communicating an inflation target. There is also latent concern that makeup accommodation, if not carefully managed, could feed inflation expectations. As a result, price level targeting remains primarily a theoretical framework and a reference point for policy evaluation, rather than an operational standard.

Price level targeting as a guide during deflation episodes

Although formal adoption is rare, price level targeting concepts have influenced how central banks respond to deflation risks and deep recessions. The intuition—that the central bank should offset past price falls with future accommodation to restore a path—has quietly informed central bank thinking during severe downturns. It is a useful mental model for evaluating whether a central bank is being too passive in the face of deflation.

See also