When Stephen Poloz says it's time to re-invent central banking, it doesn't mean he's planning a revolution. More an evolution. In practical terms, what the Bank of Canada Governor launched in his speech this week was a first step – a challenge to the sanctity of the bank's 2-per-cent inflation target.
Mr. Poloz's speech Tuesday at the University of Western Ontario was a call to arms for academics and the next generation of researchers to help solve the puzzles plaguing the world's central bankers in the post-Great Recession period. The supposed magic bullet of monetary policy over the past quarter-century – inflation targeting – failed to protect the global economy from a major crisis, and hasn't been able to cure the world's ills since.
But he won't be throwing the baby out with the bath water. It may not be perfect, but inflation targeting has worked better than just about anything before it in promoting stability and prosperity.
And while Mr. Poloz talked about the need to consider factors beyond inflation targets when setting monetary policy, the fact is that inflation targeting has worked precisely because it narrowed policy down to a single, achievable goal. Prior to inflation targeting, central bankers' attempts to target such things as money supply and exchange rates proved somewhere between disappointing and disastrous. And any central banker trying to manage multiple policy mandates has found it akin to spinning plates.
But what is on the table, as a start to this re-invention, is whether the specific 2-per-cent target level is doing the job it is meant to do – i.e. keep inflation stable at a sufficiently low level to minimize its economic distortions, but high enough to give central banks some room to adjust rate policy. The Bank of Canada's inflation-targeting mandate is the result of an agreement with the federal government that stands for renewal every five years; the current agreement expires in 2016. Mr. Poloz's speech, coming on the heels of a speech on inflation targeting just three months ago by Deputy Governor Agathe Côté – signals that the bank is gearing up for a serious airing of the merits of the inflation targeting regime; this isn't going to be a rubber-stamping of the 2-per-cent target for another five years, as some previous renewals have been.
The past half-decade of persistently weak global economic growth, disconcertingly low inflation and historically depressed interest rates have spawned a nagging concern: Central bankers have very little room to stimulate the economy through lower rates should another economic crisis arise. When the financial crisis hit in September, 2008, the Bank of Canada's key overnight rate was at 3 per cent; by December, the bank had slashed it by 1.5 percentage points, and it cut almost as much again over the first four months of 2009. If a similar emergency arose today, the bank would be starting with a thin 0.75 percentage points to play with.
A higher inflation target would imply higher interest rates, since inflation is a key component of any interest rate. (The rate of interest is meant, in part, to compensate for the expected appreciation of prices over the term of a loan or interest-bearing security.) And the idea is that if rates were typically higher because inflation expectations were higher, then central banks would have more room to cut rates when needed.
Your typical consumer is unlikely to welcome the prospect of higher inflation, but no one's looking at sending it through the roof – we're talking about a target of, say, 3 per cent rather than 2 per cent. A little consumer pain may be a reasonable trade-off for giving the central bank an adequate arsenal to protect economic and financial stability.
But the 2-per-cent target has been the cornerstone of the Bank of Canada's interest-rate policy for 20 years. The public is used to it – and as silly as it might sound, that matters a great deal.
A critical element of inflation targeting is that it anchors public and financial-market expectations: After two decades, we expect inflation to stabilize near 2 per cent because the central bank has remained committed to that target, and those expectations contribute to a self-fulfilling prophecy. Move the target, and you have two big hurdles to clear. First, you have to convince the public you're sticking with the new target for the long term, that it's not just some sort of monetary experiment. Second, the public has to re-adjust its thinking and economic decision-making to a new inflation reality. Until you clear those hurdles, you may be adding to instability and uncertainty, precisely the opposite of what the bank ultimately wants to do.
It's an uphill battle, and not one entered into lightly by any central banker at a time in history when the credibility of central banks is already being openly questioned. Mr. Poloz rightly says the bar should be high for making any change to the inflation target. He isn't wrong to challenge the status quo, but even this first modest step in his central banking reinvention would require a leap of faith.