Price-level targeting – the next big idea?
There are two main advantages of price-level targeting. The first is that we can set up contracts in nominal (cash) terms today and have a stronger expectation that they will not be eroded by inflation. At the moment, if the Bank of England makes a mistake, and (say) inflation is 10% next year, then bygones are bygones. The price level will move up to 110 and inflation targeting will continue without the Bank trying to get the price level back down again. Under a price-level target, the Bank would have to take action to get the price level down again. This is much better for investment and labour market stability because it makes it less likely that wages or bond interest, over a long period, will be worth less (or more) than we expected.
Secondly, price-level targeting helps the central bank avoid deflation traps. If the price level drops to 90 next year, then the Bank of England will have to get it back up to 100 (i.e. inflation will have to be about 11% over a period). This means that when interest rates are set at (say) 1%, a real rate of interest of -10% is being signalled – and a negative real rate of interest is just what you need to get rid of deflation.
Price-level targeting would probably help to improve monetary stability – it certainly helps improve price stability. However, it cannot prevent reckless expansion of the money supply of the sort that creates financial bubbles. It is not a cure all. However, price-level targeting must surely be better than the current system of inflation targeting. This is not just the IEA author’s conclusion. Policy Exchange’s Andrew Lilico has been advocating this for some time (including in his earliest think-tank writings which were for the IEA). If the wonks are thinking about this, then why has the Bank of England not been as active as the Bank of Canada in promoting research in this area? It is being left behind.