1. The move in recent years by a number of countries to using inflation targets in the conduct of monetary policy has also revived interest in the idea of targeting the price level as an alternative policy approach.2 The substantive macroeconomic differences between an inflation target and a price level target result from the fact that neither target can be achieved with certainty,3 While inflation will depend on the stance of monetary policy, it is also influenced by a variety of factors that are beyond the control of policymakers, including supply shocks such as commodity price changes, unanticipated shifts in the demand for money, and imperfect monetary control. Collectively, these factors cause randomness in the period-to-period outcomes for prices and inflation, and this fundamentally changes the nature of these two objectives because of what happens when the policy target is missed. If an inflation target is missed its effect on the price level is treated as a bygone, and the targeted inflation rate for the next period remains unchanged. When a price-level target is missed, policy is adjusted in the next period (or periods) to bring the price level back in line with its targeted path.

Abstract

1. The move in recent years by a number of countries to using inflation targets in the conduct of monetary policy has also revived interest in the idea of targeting the price level as an alternative policy approach.2 The substantive macroeconomic differences between an inflation target and a price level target result from the fact that neither target can be achieved with certainty,3 While inflation will depend on the stance of monetary policy, it is also influenced by a variety of factors that are beyond the control of policymakers, including supply shocks such as commodity price changes, unanticipated shifts in the demand for money, and imperfect monetary control. Collectively, these factors cause randomness in the period-to-period outcomes for prices and inflation, and this fundamentally changes the nature of these two objectives because of what happens when the policy target is missed. If an inflation target is missed its effect on the price level is treated as a bygone, and the targeted inflation rate for the next period remains unchanged. When a price-level target is missed, policy is adjusted in the next period (or periods) to bring the price level back in line with its targeted path.

IV. Inflation versus price-level targeting1

1. The move in recent years by a number of countries to using inflation targets in the conduct of monetary policy has also revived interest in the idea of targeting the price level as an alternative policy approach.2 The substantive macroeconomic differences between an inflation target and a price level target result from the fact that neither target can be achieved with certainty,3 While inflation will depend on the stance of monetary policy, it is also influenced by a variety of factors that are beyond the control of policymakers, including supply shocks such as commodity price changes, unanticipated shifts in the demand for money, and imperfect monetary control. Collectively, these factors cause randomness in the period-to-period outcomes for prices and inflation, and this fundamentally changes the nature of these two objectives because of what happens when the policy target is missed. If an inflation target is missed its effect on the price level is treated as a bygone, and the targeted inflation rate for the next period remains unchanged. When a price-level target is missed, policy is adjusted in the next period (or periods) to bring the price level back in line with its targeted path.

2. Because of the potential for base drift, targeting the inflation rate results in uncertainty about the future price level that increases with the length of the planning horizon. Thus, even though economic agents may believe that on average the central bank will hit its inflation target, that belief is consistent with a relatively wide range of possible outcomes for the future price level.4 A price-level target that is subject to the same degree of randomness, on the other hand, produces less price-level uncertainty since the authorities will systematically correct for past inflation errors (Chart 1); higher-than-targeted inflation outcomes will be followed by a lower target for inflation in subsequent periods (or vice versa) to bring the price level back in line with its targeted path. However, the greater price-level uncertainty associated with inflation targeting generally is not considered to have significant adverse effects on economic decision making over the long term.5

CHART 1
CHART 1

CANADA: PRICE-LEVEL VARIATION UNDER INFLATION VS. PRICE-LEVEL TARGETING

(Percent deviation of price level from non-stochastic case)

Citation: IMF Staff Country Reports 1998, 055; 10.5089/9781451806915.002.A004

Source: Fund staff simulations.

3. Although a price-level targeting regime offers reduced uncertainty about the future price level over longer planning horizons, it requires the monetary authorities to vary the stance of monetary policy (and the inflation rate that is targeted in any particular period) from period to period, depending on whether the price-level target was over- or undershot in previous periods. Indeed, in the special case of a fixed price-level target, the monetary authorities would need to aim for deflation on average half the time. The need for periodic deflation is often cited by critics of price-level targeting as a critical factor in favor of the inflation-targeting approach.6 However, as indicated above, a price-level targeting regime need not necessarily target a fixed price level. The price level can be allowed to rise over time, and in such a price-level targeting regime, there would be fewer instances where deflation was needed; if the targeted price-level path is sufficiently steep (i.e., the implied inflation objective is sufficiently high) and/or the variance of inflation shocks is sufficiently low, very few periods of actual deflation need occur (Table 1).7

Table 1.

Price-Level Versus Inflation Targeting: Simulation Results

(In percent)

article image
Simulations include 400 observations based on a per-period (e.g., quarterly) inflation target of 0.75 per-cent and an inflation shock that is independent and identically distributed as normal with mean zero and standard deviation 0.25 percent.

4. Apart from the possibility of having to generate periodic deflation, a prominent concern in the literature regarding the use of price-level targeting is that it may tend to result in greater variability of real output, with attendant economic costs associated with frequent adjustments in goods and factor markets. In this view, the increased variability in the stance of monetary policy under price-level targeting results in greater inflation variance (as revealed, for example, in the simulation results displayed in Table 1) and, via nominal rigidities, greater variability in output and employment.

5. However, some additional considerations serve to mitigate the concern about greater output variability with a price-level target. While an inflation targeting regime may produce less variance in inflation outcomes per period (say quarterly) than a price-level targeting regime, the variance of the average inflation rate over more than one period (say the annual average) tends to be lower under price-level targeting (see Table 1).8 Given the long and variable lags associated with the effects of monetary policy, the possible existence of employment persistence in labor markets, and the complexity of expectations formation, it is not at all clear whether a greater variance in single-period inflation rates (price-level targeting), or a greater variance in the average inflation rate over more than one period (inflation targeting) will produce greater real output instability.

6. In a rational expectations framework without nominal rigidities, it also is not inflation variance per se that generates variability in output and employment, but unanticipated changes in inflation (or the price level). Under an identical stochastic structure for inflation shocks, the unanticipated portion of the variance of an inflation-rate series is identical for a price-level or an inflation targeting regime. Consequently, the full amount of the increased inflation variance under price-level targeting would reflect predictable changes in the stance of policy, and this predictability would tend to mitigate the effects of inflation variance on real output and employment. Black, Macklem, and Rose (1997), for example, examined the role of expectations formation and find that when inflation expectations are given sufficient time to adjust to a price-level target rule, it is possible (although not guaranteed) to reduce real output variability relative to an inflation targeting rule.

7. In addition, the literature is beginning to cast doubt on the proposition that inflation targeting as implemented in practice will produce lower single-period inflation variance. That proposition relies on the use of a mechanistic (exogenous) monetary policy rule. Svensson (1996) and Gavin and Stockman (1991) have evaluated price-level versus inflation targeting regimes when central bank behavior is endogenous, in the sense that the bank’s decisions depend on the goals assigned by society (e.g., price-level versus inflation targeting), the institutional structure (including penalty rules for deviations), and the personal preferences of central bankers. Both papers point out that central bankers may have incentives to deviate from a designated inflation or price-level target. In Svensson’s model, the inflation outcome under inflation targeting depends on the level of the unemployment rate, whereas it depends on the change in the unemployment rate under price-level targeting. If the unemployment rate has a moderate degree of persistence (firms are slow to lay off workers in the face of a negative demand shock), the change in the unemployment rate is less variable than the level, and thus, inflation variability will be greater under inflation targeting than under price-level targeting. A price-level targeting regime is unambiguously superior in Svensson’s framework because it produces no price-level drift and because it results in lower inflation variability than an inflation-targeting regime. In a similar vein, Gavin and Stockman develop a model of central bank behavior in which inflation outcomes are observable but inflation (or price-level) targets are not. They show that under a reasonable penalty structure a central bank that is assigned a price-level target will have a greater incentive to adhere to that target than one assigned an inflation target. In their model, policymakers have an increased incentive under inflation targeting to blame overshooting on random events and to maintain an inflation bias.

8. In sum, the superiority of a policy of inflation versus price-level targeting hinges largely on whether a price-level target will tend to induce greater macroeconomic instability. This issue remains unsettled. Until recently, the dominant view in the literature was that greater price-level uncertainty over distant planning horizons associated with inflation targeting would impose relatively smaller social costs compared with the costs potentially arising from greater variability in output and employment associated with price-level targeting. The latter proposition, however, has been challenged on a number of grounds. If the expectations of economic agents are formed utilizing information about the nature of the monetary-policy regime, the increased variability in the stance of monetary policy associated with price-level targeting need not imply a concomitant increase in macroeconomic instability. The same conclusion can be reached if the actions of central bankers depend on the monetary policy rule assigned to the central bank, the institutional structure for implementing the policy rule, and the preferences of the central bankers. In that case, a price-level targeting regime need not produce increased single-period inflation variance and thus, regardless of assumptions about expectations, need not produce increased output and employment variability.

List of References

  • Black, Richard, Tiff Macklem, and David Rose, 1997, “On Policy Rules for Price Stability,” Proceedings of a conference on Price Stability, Inflation Targets and Monetary Policy, held at the Bank of Canada, May (forthcoming).

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  • Gavin, William T. And Alan C. Stockman, 1991, “Why a Rule for Stable Prices May Dominate a Rule for Zero Inflation?” Federal Reserve Bank of Cleveland Economic Review 27(1).

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  • Fischer, Stanley, 1994, “Modern Central Banking,” in Forrest Capie and others (eds.), The Future of Central Banking, (Cambridge: Cambridge University Press).

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  • McCallum, Bennett T., 1997, “Issues in the Design of Monetary Policy Rules,” paper presented at the conference Recent Developments in Macroeconomics, Federal Reserve Bank of San Francisco (March 7-8).

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  • Svensson, Lars E.O., 1996, “Price-Level Targeting vs. Inflation Targeting: A Free Lunch?” NBER Working Paper No. 5719 (Cambridge, Massachusetts: National Bureau of Economic Research).

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1

Prepared by Michael Leidy.

2

See, for example, Svensson (1996).

3

Price-level targeting need not involve a stable price level (a zero inflation rate) as its objective. Instead, provision could be made for a predetermined rate of increase in the price level over time (a nonzero inflation rate).

4

Chart 1 shows the results of four simulations in which the targeted inflation rate is set at 0.75 percent per period, and the inflation outcome in each period deviates from the target reflecting a random disturbance that is assumed normal with a mean of zero and a standard deviation of 0.25 percent. This implies that a 95 percent confidence interval for the inflation outcome in each period ranges from 0.25 percent to 1.25 percent.

5

McCallum (1997, pp. 18–19), for example, points out that with a zero inflation target and a price level that behaves as a random walk with the error component’s standard deviation at a quarterly frequency set at 0.45 percent (which he identifies as approximating the one-step ahead forecast errors for the United States from 1954 to 1991), a 95 percent confidence interval for the (log) price level in 20 years would be plus or minus 8 percent.

6

See, for example, Fischer’s (1994, p. 282) observation that, “… there are good reasons not to target negative inflation. Price-level targeting is thus a bad idea, one that would add unnecessary short-term fluctuations to the economy.” However, the paper subsequently notes (p. 284) that a price-level target need not imply zero inflation.

7

In the four simulations described in footnote 4, in no period would it have been necessary to pursue a deflationary monetary policy in order to achieve the predetermined price level for the next period. Over 1,600 observations, the per-period targeted inflation ranged from a low of 0.05 percent to a high of 1.56 percent. The corresponding per period inflation outcome (which reflects the targeted inflation and the random shock) did, however, produce 20 periods (1.25 percent of the total realizations) of deflation. Under the same stochastic properties, outcomes under an inflation targeting regime resulted in just one realization of deflation.

8

The reason is that while the inflation targeting regime ignores under and overshooting of targeted inflation rates, a price-level targeting regime corrects for over and undershooting and, in so doing, tends on average to be closer to the targeted trend increase over a series of periods. In technical terms, with an identical stochastic structure for serially independent inflation shocks, the inflation outcome in the case of price-level targeting will display negative serial correlation as a result of the policy rule, whereas the inflation outcome under inflation targeting will be serially uncorrelated.

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Canada: Selected Issues
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International Monetary Fund
  • CHART 1

    CANADA: PRICE-LEVEL VARIATION UNDER INFLATION VS. PRICE-LEVEL TARGETING

    (Percent deviation of price level from non-stochastic case)