IF IT’S BROKE, FIX IT
Whoever forms the next federal government is going face a tricky question: What to do about the Bank of Canada? Monetary policy is a subject that political parties don’t spend much time talking about, and for good reason: history has taught us that monetary policy is more effective in achieving its goals if day-to-day decisions are made — and are seen to be made — without the interference of politicians. But it’s the politicians who — quite rightly — set the goals for monetary policy.
Under the current system, the Minister of Finance (who is ultimately responsible for monetary policy) sets out an objective for the Bank of Canada, and the Bank is free to use whatever instruments it sees fit to carry out its mandate. The current inflationtargeting mandate expires at the end of 2016, and the case for simply renewing the status quo is not the slamdunk it was in 2001, 2006 or even in 2011.
The two previous mandates were carried out almost to the letter: the instructions from the Minister of Finance were to deliver annual rates of inflation of the Consumer Price Index (CPI) between one per cent and three per cent, with a target of two per cent, and that’s what the Bank of Canada delivered. The average annual CPI inflation rate between 2001 and 2006 was 1.97 per cent, and it averaged 1.96 per cent between 2006 and 2011. Under the circumstances, the decision to renew those mandates was an easy one to make: if something isn’t broken, you don’t try to fix it.
Things have gone less well in the current mandate, which began in November of 2011. Since then, the CPI has grown at an average annual rate of only 1.22 per cent. The cumulative effect of this undershooting is a CPI level in April that was 2.5 per cent less than what it would have been if the inflation target had been met each month.
This is a problem that the federal government hasn’t had to face yet. It was easy enough to renew the existing inflation target and express continued confidence in the Bank of Canada after a successful mandate. But what do you do when the target isn’t met?
Right now, the answer is “nothing”: the inflation target is forward-looking, and past deviations from target are forgiven, if not forgotten. Previous forecast errors are mostly important as a guide for updating future projections. But persistent deviations from target are less easy to shrug off.
There are alternatives to this forward-looking approach to inflation targeting: what if the Bank of Canada acted to offset past errors? This is the idea behind price level targeting: episodes in which inflation fell below target would be offset by a deliberate attempt to engineer above-average inflation to make up for it. If price level targeting had been in effect during this mandate, then the Bank of Canada would be aiming for an average annual inflation rate of 2.7 per cent between now and December 2016, in order to make up for the earlier periods of too-low inflation.
Price level targeting has its supporters, both inside and outside the Bank of Canada. If the main achievement of inflation targeting has been to make inflation more predictable, then price level targeting would be a clear improvement. To the extent that short-term deviations from trend are deliberately offset by policy, the mediumand long-term outlook for inflation becomes more predictable. Under inflation targeting, short-term errors accumulate as you make forecasts further out into the future; under price level targeting, these errors cancel out.
Another advantage of price level targeting is that monetary policy becomes more effective. The policy stance of a central bank is often measured by the “real” interest rate: the actual interest rate less expected inflation. If inflation expectations are anchored at two per cent, then the lower bound for the real interest rate is -2 per cent: interest rates (usually) cannot go below zero. An inflation target imposes a limit on how expansionary monetary policy can be.
This limit is relaxed under price level targeting. If the CPI drifts below trend, the Bank of Canada would target an above-trend inflation rate, and higher inflation expectations mean lower real interest rates. The same reasoning works in reverse: a contractionary monetary policy would be even more effective if the Bank of Canada wanted to offset a burst of high inflation.
Another monetary policy regime that makes use of similar arguments is nominal GDP (NDGP) targeting. NDGP is real GDP — the measure of the quantity of goods and services produced and sold — times the price level. Under NGDP targeting, the Bank of Canada would not be content with simply returning prices to trend. If real GDP growth remained sluggish, monetary policy would continue to be expansionary, even if the price trend had been reestablished.
Price level targeting had been the subject of much research and was seriously considered as an alternative to inflation targeting when the 2006 mandate expired. (NGDP targeting is a newer idea and has been less studied.) The sentiment in 2011 was that since inflation targeting had been a success in its own terms, the bar was pretty high for making the case for an alternative monetary policy regime.
The next time around may be different. Inflation targeting may have served us well when the immediate threat was high and variable inflation, but it has shown some weakness as a guide for monetary policy in a low-inflation world. “It ain’t broke so don’t fix it” will be a less compelling argument in 2016 than it was in 2011.
Although politicians don’t and shouldn’t have much to say about the day-to-day conduct of monetary policy, they are responsible for setting out the goals that monetary policy should achieve. Any political party that aspires to govern after the next election should be thinking hard about what sort of mandate that they would give the Bank of Canada in 2016. And they should be telling voters what they’re thinking.
The Bank of Canada has been missing its inflation targets. This coming election offers us a good chance to consider new policies