Discussion Paper Series 2019-E-13

Alternatives to Inflation Targeting in Low Interest Rate Environments

Carl E. Walsh

The challenges of a low interest rate, low inflation environment have led to calls to re-examine the basic framework of flexible inflation targeting (IT). Interest in alternatives such as price-level targeting (PLT) and average inflation targeting (AIT) arises from the way in which these policy regimes cause inflation expectations to work as automatic stabilizers, a factor that can be of major importance if the central bank is constrained at the ELB. I show that the performance of PLT deteriorates significantly relative to IT and AIT in the presence of wage rigidities, shocks to productivity, and deviations from rational expectations. A central bank able to credibly commit to the optimal policy consistent with PLT is likely to face a much higher probability of needing balance sheet policies to implement policy than would be the case under IT or AIT. These results suggest it is too early to count IT out in the competition over policy design.

Keywords: Optimal monetary policy; Inflation targeting; Price-level targeting; Average inflation targeting

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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