What is Price-Level Targeting?
Price-level targeting is an economic strategy whereby a central bank tries to reestablish an overall price level rather than reestablish a particular inflation rate.
How Does Price-Level Targeting Work?
For example, let's assume that inflation is usually 4% per year in the United States, but then it drops to 1% per year. In this case, the central bank (the Federal Reserve, in the United States) is obliged to try to prevent the economy from stagnating by stimulating it via monetary policy.
Remember that in a deflationary economy, prices are lower than they used to be. So, the Fed can either try to re-establish the rate of price inflation, or it can re-establish the old prices at which goods and services used to be bought and sold (which involves a bigger jump). The Federal Reserve uses the Consumer Price Index (CPI) for both inflation and price-level targeting.
If the Fed decided to use price-level targeting, it could reduce the nominal interest rate via monetary injections in an effort to expand consumption and output. As consumption increases (i.e. demand increases), the price of goods and services should increase as well.
Why Does Price-Level Targeting Matter?
Price-level targeting can sometimes be more effective than inflation targeting because the target is more concrete. But most developed economies do not use price-level targeting because it forces them to abandon their desire to maintain a steady level of inflation. Because consumers and investors often base their expectations on past inflation rates rather than price levels, they may become uncertain about future prices (because of the degree and suddenness of price changes) and about the credibility of the Federal Reserve.