Central banking hits its limits

It was good to have C. D. Howe Institute President Bill Robson’s clarification/reminder that the Bank of Canada’s recent interest rate cut was all about inflation. With the fall in oil prices, inflation is trending south of the Bank’s two per cent target. When the forecast is for less-than-target inflation the Bank’s rule is to expand. That’s what the forecast said. That’s what the Bank did. All is right with the world. What struck the markets as a bolt from the blue was predictable by anyone paying attention to the inflation forecasts. The Bank’s policy of transparency and predictability remains intact.

That’s certainly preferable to the story told most places in the media, which was that the Bank, concerned by contraction in the oil patch, was doing its best to jolt growth elsewhere in the economy to make up for real economic losses in Alberta. Central banks can do many things — not all good, some very bad — but offsetting real hits to an economic sector isn’t one of them.

If there’s a crisis in the financial markets (one not of the Bank’s making, at least), Bank action can reassure economic actors economy-wide about how it will provide liquidity and take other measures and be open and forthright about what it’s doing. But when Saudi Arabia gets into a pumping war with the U.S., Russia and Iran there’s not a lot a central bank can do. The sharp drop in oil prices is going to disemploy capital and labour in that sector and moving interest rates up or down won’t help turn rig-operators into diecutters, home-builders or lab technicians. There’s only so much oil the Bank could buy. And we have a national labour market to take care of the adjustment, anyway. It’s not clear what the Bank could add.

All that said, it’s hard for anyone who lived through the 1970s to get his head around to the new view that lower-thanexpected inflation is a bad thing. Regarding Europe, for instance, the Bank’s Monetary Policy Report says the oil-driven decline in inflation might even reach a point where “inflation expectations could become de-anchored.” What that means is that if European prices flatten out, Europeans may lose faith in their central bank’s promise to deliver two per cent inflation. Having less of a bad thing evidently will disappoint them. The promise is what counts. The level of prices doesn’t.

After two decades in which central bankers couldn’t hit the side of a barn door it was important to citizens and central bankers alike that they find a target, almost any target, that they actually could hit. Aiming directly at inflation, rather than obliquely through interest rates or changes in the money supply, has proved a reachable goal. The effect on people’s confidence in central bankers (and on finance ministers when they’ve been able to hit their budget targets) has been positive and helpful. But now after two decades in which central bankers have demonstrated their skill, maybe it’s time to find them a better target.

If, as promised, the Bank of Canada does produce two per cent inflation from now on, then in 30 years, just a generation away, prices will be 75 per cent higher than they are today. In 50 years, through the miracle of compound interest, they’ll be two and a half times higher. In a century, they’ll be fully seven times higher.

Maybe a generation ahead, let alone a century, is too far for policymakers to think about. It might be too far for elected politicians to think about. But central bankers are appointed, not elected, and though in theory they can be fired in prac- tice they’re a lot like judges: once in place, hard to displace. If they don’t think about the long term, who else in the policy loop is going to? Plus, the effect of inflation on the price level is not full of unknowables and imponderables, like the effect of carbon emissions on global temperatures. It’s basic arithmetic. Run inflation at a given rate for a given time and the effect on the price level is certain.

In my history of economics class this term we’ve been reading Roger Backhouse’s lively review of the discipline, The Ordinary Business of Life. Backhouse tells how, as in the rest of Europe, “inflation was a serious problem in sixteenthcentury England. In earlier centuries prices had fluctuated, but there had been no long-term tendency for prices to rise, whereas by the end of the sixteenth century wheat prices were between four and five times higher than they were at its beginning.”

Hmm. Prices rising five-fold in a century is a “serious problem.” Since 1914 in this country, the Bank of Canada’s Inflation Calculator tells us, prices in general have risen 19-fold. In the United States in the same period, according to the Bureau of Labor Statistics, they’re up almost 24-fold. In the United Kingdom, says the Bank of England, almost exactly 100-fold. By those lax standards, a future in which prices rise “only” seven-fold in a century may well look like price stability.

But this is the 21st century. Surely with all our economic knowledge and expertise we can do better than the 16th. After all, in the 16h century they didn’t even have central bankers.

Wait, you don’t think … ? Nah, couldn’t be.

Central banks can do many things — not all good, some very bad — but offsetting real hits to an economic sector isn’t one of them