Bank of Canada Plans Thorough Review of Inflation Targeting

(Bloomberg) -- The Bank of Canada is preparing the most thorough review of its inflation targeting mandate in three decades to gauge whether it would be better off switching to a new framework, the central bank’s No. 2 official said.

In a speech Tuesday in Montreal, Senior Deputy Governor Carolyn Wilkins said the central bank will do a “side-by-side assessment” of alternatives to its inflation targeting regime. That framework is facing a serious challenge from historically low neutral rates, which may diminish the bank’s ability to combat future downturns and encourages households to take on excessive risk.

“There is no doubt that our inflation-targeting framework has promoted the economic and financial well-being of Canadians,” Wilkins said in prepared remarks on the Bank of Canada’s preparations ahead of the mandate’s renewal in 2021. “A decade of experience in the post-crisis world, though, shows us it is not perfect. It is time to conduct a thorough review of the alternatives,” she said.

The comments are the strongest indication yet that the central bank will seriously consider changes to a framework that came into effect in the early 1990s and requires the bank to narrowly focus on a single objective: to keep prices stable.

2 Percent

Operationally, that means aiming for a 2 percent inflation target over its so-called forecast horizon of about two years -- though some flexibility has been built into the system.

The inflation targeting framework and overall focus on price stability -- which is widely followed in many advanced economies -- has been faulted for helping to fuel the financial imbalances that led to the last global crisis, and also proved to be insufficient in giving economies enough firepower to help recover from the recession.

Wilkins pointed out the regime could be challenged in the future by the long-term trend of falling global rates, which means borrowing costs will remain low even after the central bank removes all its stimulus. That will give it less firepower in the event it needs to respond to an economic downturn.

Low borrowing costs also mean the economy will continue to be exposed to “booom-bust” financial cycles under inflation targeting, since it encourages households to take on debt.

“My bottom line here is that although our inflation-targeting framework has served us very well, we should look for ways to improve it,” Wilkins said.

Three Criteria

The Bank of Canada will use three criteria to assess alternatives: the objectives should be short-term stabilization and cyclical issues rather than long-term matters, they need to support the greater good and consider implications on things like income distribution and financial stability, and they need to be robust in bad times as well as good.

Wilkins outlined some of the pros and cons of some alternatives: raising the inflation target, targeting the price level, developing a dual mandate and targeting nominal GDP.

The central bank will also need to examine how to improve the clarity around its toolkit of unconventional policies, which will be needed regardless of what framework is in place, Wilkins said. Another question for policy makers, according to Wilkins, is what role is there for fiscal and macroprudential policies to help reduce the burden on monetary policy.

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