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Bank of Canada should stick to inflation targeting

Sean Kilpatrick/Sean Kilpatrick/The Canadian Press

The Bank of Canada's mandate is due for renewal before the end of the year, and recent reports suggest that the existing mandate will be renewed with little or no changes.

By any measure, the last twenty years of inflation targeting can only be considered an unqualified success: inflation has been low and stable for a generation. This is a remarkable achievement, especially in the eyes of an economist who remembers the twenty years previous to the targeting regimes. Although the Bank's research staff is continually looking for ways in which the Bank's mandate might be refined, it is generally acknowledged -- in the expression that Bank staffers like to use -- that "the bar is high" when it comes to changing the Bank's mandate.

There have always been other options, of course. The feasible ones all involve targeting a nominal -- that is, measured in current dollars -- variable such as the exchange rate, the money supply or the price of a commodity such as gold. All three of these options have been tried and abandoned. Another option -- targeting nominal GDP -- is the subject of much recent attention in the U.S., and will be the subject of a future post.

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Infeasible mandates include anything involving targets for real quantities, like real GDP or the unemployment rate. The Bank of Canada has the power to create money, not wealth.

Inflation isn't the only thing that central banks should be concerned with -- a point that seems to escape the European Central Bank. The events of the past few years have brought the importance of financial markets to the fore. If financial markets are not functioning properly, a strict adherence to the inflation targeting mandate may increase the likelihood of a crisis. Even if the Bank of Canada thought that inflation was likely to go above target, the continued risk of a euro zone financial emergency would be an argument for not increasing interest rates right away. Another scenario might involve increasing interest rates in order to prick an asset price bubble.

Unfortunately, the Bank can only use one monetary policy instrument at a time, and it cannot use it to do two things at once. But so far, the Bank's existing mandate has been shown to be flexible enough to adjust to conditions in financial markets during the recent crisis.

One idea that may be implemented eventually is price-level targeting. In the existing inflation-targeting framework, past deviations from target are forgotten when setting policy; only future inflation rates are considered. So even though long-term expectations of inflation may be well-anchored by a 2 per cent target, forecast errors accumulate as the forecast horizon gets longer.

Under price-level targeting, the central bank commits to staying on a path for the price level. If inflation goes below target, the Bank will try to engineer inflation rates above target to compensate. Similarly, if inflation overshoots the target, the Bank will try to correct the mistake by engineering a period of low inflation.

There are two principal advantages of a price-level target:

1. More certainty about prices in the longer term. Instead of accumulating, deviations from target are cancelled out over time.

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2. More aggressive monetary policy during slumps. Recessions drive inflation below target, so a central bank with an inflation target will adopt an expansionary stance. But a central bank with a price-level target will want to see above-target inflation rates to get back to its target, and it will adopt an even more expansionary stance. Recessions would be generally shorter and milder under a price-level target.

The Bank of Canada has put a great deal of effort into studying price-level targeting, and there seems to be a broad consensus about its merits. And in fact, the past history of the Consumer Price Index is consistent with what the price-level target would produce -- albeit by happy coincidence and not by design. There's not much to choose between what a price-level target would have produced and what we actually observed.

Nonetheless, there are two reasons why price-level targeting won't be in the next Bank of Canada mandate. The first is the communications challenge. It took a lot of work to adapt Canadians' expectations to a single, fixed inflation target. It will be even harder to adapt to a framework of constantly changing short- and medium-term inflation targets that depend on whether or not the price level is above or below its target.

But the best reason for sticking with the inflation target is that after several decades of flailing about, the Bank of Canada has a policy framework that works well. We should think twice before trying to fix something that doesn't appear to be broken.

Stephen Gordon's recent posts and Twitterfeed can be viewed here.

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