Indeed, a price-level target may be an effective way of implementing the fully optimal monetary policy  BIS Review 111/2010  13  under commitment (Vestin, 2006). A considerable body of research expands on this idea; see e.g. Ambler (2009) and the references therein. Why might price-level targeting generate less variability of inflation and output than an inflation target, as it is tempting to think the opposite should be the case? Under price-level targeting, an adverse shock to demand, which pushes the price level below its target path, necessarily requires higher inflation in the future in order to return the price level to its target path. Assuming that private agents understand this, expected real interest rates fall, so boosting demand today. Inflation expectations therefore act as a more effective automatic stabilizer than they do under inflation targeting. By the same token, an adverse supply (markup) shock, which raises the price level above its target path and depresses output today, leads to lower expected future inflation. But, in the standard New Keynesian Phillips curve describing pricing behaviour, inflation is positively related to expected future inflation. Hence the lower expected future inflation acts to offset the impact of the supply shock by moderating the rise in today’s price level. A corollary of inflation expectations becoming an automatic stabiliser under price-level targeting is that it reduces the extent to which the nominal policy rate needs to fall to offset an adverse demand shock.
These costs are significant, though still modest compared to the output falls during the recession of around 8 per cent in the United States and over 10 per cent in the United Kingdom, relative to a continuation of pre-crisis trends. So this could be an insurance premium worth paying if there was a reasonable chance that it could have prevented these falls. (The regression model obviously does not capture the inherently nonlinear link between the earlier credit/house-price boom and the subsequent near-collapse of the banking system and associated contraction in output; any gain from this more restrictive policy in terms of reducing the likelihood of a future bust is therefore absent – that is why the extent of the downturn in 2008–9 is largely unaffected.) Although the impact on house prices is quantitatively significant, the limited impact on credit – arguably the more important variable in determining the vulnerability of the system – as well as the plethora of other factors at work in creating the crisis, makes us reluctant to conclude that it would have had a major impact on the probability of a crisis materialising. But ultimately this is very much in the eye of the beholder, as we cannot be sure what would have happened under the alternative policy. There may nevertheless be times when a well-judged monetary policy intervention is particularly effective in curbing financial excesses.