Price level versus inflation targeting - the new monetary policy

The orthodoxy of monetary policy has been inflation targeting for almost two decades. Central banks are still trying to fit this orthodoxy into the current crisis, yet there is a growing belief that there may be a need for a new view, price level targeting. In this monetary regime, the central bank will try to control the level of prices and not inflation. So if there was a deflation of one percent there will have to be a corresponding increase in future inflation of three percent if the long-term target of the price level is expected to increase by 2 percent per year.

Deflation has to be offset with higher inflation in the future to re-inflate or adjust nominal prices. This will keep real prices flat, so rel price adjustments would not be able to clear the markets. An interesting theory, but how will it be implemented and what will be the effect on markets. It is hard to say but we think that this policy story is worthy of significant review and will be a focus of our research.