Taking a Longer Look at the Inflation Target: Canada Eco Watch

(Bloomberg) -- Less than a year since completing the last review of its inflation-targeting mandate, the Bank of Canada is starting to prepare for the next one in 2021.

Consultations kick off in Ottawa on Sept. 14 with an invitation-only workshop of economists that will be webcast on the central bank’s website. It’s an early public start to the process, and comes amid a growing sense that a deeper look at the inflation target is needed after almost a decade of poor economic performance.

For example, an argument could be made the bank kept monetary policy too tight. It consistently predicted much better outcomes, and set its monetary policy accordingly to keep a lid on inflation. But the inflation never materialized, and the economy continued to fall below expectations.

The Theory

Since the 1990s, the bank has been narrowly focused on a single objective: to keep prices stable. Operationally, that means aiming for a 2 percent inflation target over its so-called forecast horizon, a period of about two years.

If it looks like inflation is heading above target, the bank would generally interpret that as a signal higher interest rates are required to cool the economy. Likewise, inflation heading below target usually signals lower rates are needed.

The whole framework assumes a predictable relationship between inflation and output.

Inflation Record

Up until the recession, the targeting mandate was extremely successful. Total annual inflation as measured by the consumer price index averaged exactly 2 percent between 1995 and 2008, with the economy growing steadily at that time.

Since the financial crisis, the bank has consistently undershot its target. During Mark Carney’s tenure, CPI averaged 1.7 percent. Under Stephen Poloz, who became governor in 2013, the index has averaged about 1.4 percent, the lowest among Canada’s inflation targeting central bankers.

The economy, meanwhile, has been in a near-constant state of under-performance, defying the bank’s recurring predictions that a turnaround is near. According to its estimates, Canada’s economy has had excess capacity -- resources going unused -- for 35 straight quarters. That’s a long time.

Blame

It’s easy to blame the poor record on the fact that some events are just unpredictable, like the plunge in oil prices that started in 2014. Some of the lapse could be attributed to forecasting errors, or changing parameters in models that may simply need tweaking. Last fall, the bank replaced its long-standing measure of core inflation, citing a deterioration in its usefulness, for three new measures.

Or, maybe something fundamental really has happened to make the relationship between inflation and output unpredictable, something that may require a rethink of the paradigm. Low inflation is baffling authorities throughout the developed world, an issue that will no doubt be raised at next month’s workshop.

If the relationship is breaking down, “you can still target inflation, but it’s not really doing what you want to to stabilize the economy,” said Nick Rowe, a professor at Carleton University, and among the invitees to next month’s conference. “It’s not giving you a signal for your mistakes.”

Week Ahead

• Wholesale trade (Monday, 8:30 a.m.)
• Bloomberg Nanos consumer confidence index (Monday, 10 a.m.)
• Retail sales (Tuesday, 8:30 a.m.)
• Employment insurance, quarterly financial statistics for enterprises (Thursday, 8:30 a.m.)

Way Forward

What can be done to give the central bank more tools to counter listless growth? One option is to raise the inflation target, an outcome that would have produced looser policy during this period of under-performance. Another, favored by Rowe, is to target nominal GDP growth, which would allow policy makers to effectively target both inflation and output. A hybrid.

Alternatively, they can determine that there are limits to what monetary policy can actually do at low interest rates, given the financial system imbalances caused by low-for-long interest rates.

The debate is taking on added significance as the economy enters what looks to be a growth spurt. The bank, seeing inflation around the corner again, has put the country on a rate hike path that raised some eyebrows within Prime Minister Justin Trudeau’s government.

If the federal government isn’t happy with the situation, they have no one to blame but themselves. The governing Liberals had an opportunity for a serious rethink of the mandate last year, but chose to sign off on the bank’s recommendation to leave things as they were. At the time, it was a new government with different priorities.

Expect much more involvement in the next review -- whoever is in power.

--With assistance from Erik Hertzberg

To contact the reporter on this story: Theophilos Argitis in Ottawa at targitis@bloomberg.net.

To contact the editors responsible for this story: Theophilos Argitis at targitis@bloomberg.net, Chris Fournier