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Inflation Targeting vs Price Level Targeting

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"Inflation Targeting vs Price Level Targeting"

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I want to try to keep doing posts that explain some basic monetary policy concepts, since I think these issues are important but most people aren’t very familiar with them. Today, let’s consider the difference between two kinds of targets a central bank can set for itself. One would be inflation targeting and the other would be price-level targeting. The inflation rate is the rate at which the price level increases, so these are similar ideas. Indeed, in a world of perfect execution they’d be equivalent. This is what the world looks like if the central bank is successfully hitting a two percent inflation target:

cpi2percent

And here’s how things look if the central bank is successfully hitting a target for two percent growth in the price level:

cpi2percent

It looks the same. Because these are the same thing. But it looks different if you factor in the inevitable occurrence of problems.

For example, suppose the economy has a sharp unexpected burst of deflation:

catchup

Here the blue line represents somewhat successful inflation rate targeting—after a few problems, the inflation rate regains stability at two percent. The green line, by contrast, represents somewhat successful price level targeting—after a few problems the price level catches up with its previous two percent annual growth path. That means a couple years of below-trend inflation are met with some years of faster-than-usual inflation to make up the lost ground. This is a subtle distinction, but for someone who signed a long-term contract denominated in nominal terms back in 2007, it has big implications for the financial state of things in 2011, 2012 and beyond.

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