A Primer on Inflation Targeting

A Primer on Inflation Targeting Publication No. 2011-111-E 9 November 2011 Brett Stuckey International Affairs, Trade and Finance Division Parliamentary Information and Research Service

A Primer on Inflation Targeting (In Brief) HTML and PDF versions of this publication are available on IntraParl (the parliamentary intranet) and on the Parliament of Canada website. In the electronic versions, a number of the endnote entries contain hyperlinks to referenced resources. Ce document est également publié en français. Papers in the Library of Parliament s In Brief series provide succinct, objective and impartial overviews of current issues. They are prepared by the Parliamentary Information and Research Service, which carries out research for and provides information and analysis to parliamentarians and Senate and House of Commons committees and parliamentary associations. Publication No. 2011-111-E Ottawa, Canada, Library of Parliament (2011)

CONTENTS 1 MONETARY POLICY IN CANADA... 1 2 WHY INFLATION MATTERS... 3 3 PROS AND CONS OF INFLATION TARGETING... 3 3.1 Pros... 3 3.2 Cons... 4 4 ALTERNATIVES TO AN INFLATION-TARGETING REGIME... 4 4.1 Decrease the Inflation Target... 4 4.2 Broadened Mandate to Mitigate the Effects of Asset Bubbles... 5 4.3 Price-Level Targeting... 5 LIBRARY OF PARLIAMENT i PUBLICATION NO. 2011-111-E

* On 8 November 2011, the Bank of Canada and the federal government renewed their inflation-targeting agreement, which guides monetary policy in Canada. Monetary policy is focused on how much money is circulating in the economy and what that money is worth, while inflation can be defined as a persistent rise in the average price of goods and services or the cost of living. The main objective of Canada s monetary policy, the conduct of which is the responsibility of the Bank of Canada, is to keep inflation low and stable. Inflation targeting refers to a system in which monetary policy decisions are made, implemented and communicated according to a clearly stated inflation target or target range. Debates about the merits of such a monetary policy framework have been occurring in Canada for at least two reasons: global instability associated with the recent financial and economic crisis, and consideration of the merits of changes to the 2006 inflation-targeting agreement between the Bank of Canada and the federal government. Although inflation targeting is thought to be successful in Canada and in other countries that employ such a framework, some analysts believe that Canada s monetary policy regime could be improved through such means as a change to the inflation target or the target range, a clear mandate for the Bank of Canada to take action to mitigate the effects of asset bubbles as they appear, and/or a change from targeting inflation to targeting prices. This paper describes how the Bank of Canada conducts monetary policy, explains how inflation affects the economy, identifies some of the pros and cons of inflation targeting, and mentions several of the alternatives to inflation targeting. 1 MONETARY POLICY IN CANADA The Bank of Canada Act, enacted in 1934, stipulates in its preamble that the Bank of Canada shall mitigate fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action. The Bank of Canada carries out monetary policy by setting the target for the overnight interest rate, which is the rate at which financial institutions borrow and lend one-day funds among themselves. When the Bank of Canada alters this very short-term interest rate, other interest rates such as the prime lending rate set by financial institutions usually move in tandem with it. Changes in these rates affect consumers, with implications for upward and downward pressure on prices, and consequently the inflation rate. Since 1991, the Bank of Canada and the federal government have formally agreed on an inflation-targeting regime. The initial objective of this joint agreement, which contained a target inflation rate of the midpoint of a 2% 4% target range, was to LIBRARY OF PARLIAMENT 1 PUBLICATION NO. 2011-111-E

reduce inflation as measured by the All-Items, or total, Consumer Price Index (CPI) 1 from a rate of about 5% in late 1990 to 2% by the end of 1995; in fact, a 2% rate was achieved in January 1992. A new agreement with a target range of 1% 3% was reached in 1993, and the five subsequent agreements 2 the most recent of which was signed in November 2011 have focused on keeping total CPI at an annual rate of 2%, the midpoint of that range. In conducting monetary policy, the Bank also considers core CPI, which excludes eight of the most volatile components in the basket of goods and services that is used to calculate the CPI and adjusts the remaining components to remove the effect of changes in indirect taxes. Figure 1 shows core and total CPI, 3 and the 1% 3% target range and its 2% midpoint, since the first joint agreement was reached in 1991. Since 1993, when the 1% 3% target range was agreed to, core CPI has exceeded the upper limit of the target range once and has been below the lower limit of the target range three times. 4 As indicated in Figure 1, total CPI is much more volatile than core CPI. Figure 1 Bank of Canada Target Range for the Consumer Price Index and the Total and Core Consumer Price Index, January 1991 September 2011 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% Core CPI Total CPI Lower Bound Upper Bound Target Note: The 2% target, as the midpoint of the target range of 1% 3%, was agreed upon in 1993. Source: Figure prepared by the author using data obtained from Statistics Canada, CANSIM table 326-0022. The Bank of Canada prevents the inflation rate, as measured by total CPI, from moving outside the target range by making changes to its main policy tool, the target for the overnight interest rate. Changes to the target for the overnight rate typically alter borrowing costs for individuals and businesses, thereby affecting consumption LIBRARY OF PARLIAMENT 2 PUBLICATION NO. 2011-111-E

and investment. For example, increases in economic activity sometimes lead to upward pressure on prices and thereby inflation. To counteract this pressure, the Bank of Canada may increase the target for the overnight rate, which tends to raise borrowing costs and reduce consumption, all other things being equal. With reduced consumption, there may be downward pressure on prices. A change in the target for the overnight rate could also affect the relative value of the Canadian dollar. Through its impact on interest rates set by financial institutions, an increase in the target for the overnight rate could make investments in Canada relatively more attractive because of higher expected rates of return. All other things being equal, a rise in foreign investment would increase demand for the Canadian dollar and put upward pressure on its relative value. Furthermore, an appreciation in the relative value of the Canadian dollar makes foreign goods relatively less expensive and could reduce inflationary pressures associated with demand for domestic goods and services. The opposite effects would be expected in the case of a decrease in the target for the overnight rate. 2 WHY INFLATION MATTERS Broadly speaking, inflation may result from too much money chasing too few goods, for one of two reasons: an increase in household, business and/or government spending, assuming that supply is constant in the short term, or an increase in the money supply. Alternatively, or in addition, inflation may be the result of cost-push inflation, which involves increases in the costs of production that lead producers to pass increased costs to consumers in the form of higher prices. Volatile inflation makes investment decisions more difficult because the future cash flow associated with an investment is more uncertain. Furthermore, from the perspective of the value of money over time, inflation reduces the purchasing power of those who hold cash and those with fixed incomes. Although inflation may have negative effects, a general decrease in prices deflation may also be undesirable, in part because it may encourage individuals, businesses and governments to delay spending as their purchasing power increases over time. Economists generally believe that a rate of inflation should be stable and low but high enough to prevent deflation. 5 3 PROS AND CONS OF INFLATION TARGETING 3.1 PROS One of the main arguments in favour of inflation targeting is that it increases public confidence about the stability of future prices. When a central bank adopts an inflation-targeting framework, a clear signal is sent that inflation control is a priority. When this framework is credible and well communicated, people expect prices to be relatively stable at or around the stated inflation target, thereby allowing consumers and businesses to manage their finances with greater certainty about the future purchasing power of their savings and income. LIBRARY OF PARLIAMENT 3 PUBLICATION NO. 2011-111-E

Adopting an inflation target does not mean, however, that the goal of economic growth is abandoned. In fact, some believe that controlling inflation is the best contribution that monetary policy can make to economic growth. According to the current governor of the Bank of Canada, [t]he relentless focus of monetary policy on inflation control is essential and remains the best contribution that monetary policy can make to the economic and financial welfare of Canada. 6 3.2 CONS Some commentators who do not support inflation targeting note its lack of flexibility, since it focuses on inflation at the expense of other monetary policy objectives, such as full employment. For example, inflation targeting may limit the ability to respond effectively to economic crises, since its focus is relatively narrow. Furthermore, if an economic downturn and low inflation are concurrent, such as occurred during the recent financial and economic crisis, an inflation-targeting framework is limited in its ability to stimulate the economy once it reaches an effective zero bound. Since the target for the overnight rate cannot be reduced below 0%, if further monetary policy stimulus is required, extraordinary measures may be required. 7 Moreover, the recent subprime mortgage crisis in the United States, and the resulting financial and economic crisis, have shown another aspect of the inflexibility of inflation targeting. A number of commentators believe that focusing exclusively on inflation reduces the extent to which central banks are able to ensure stability in asset markets, such as the housing market. Although asset prices, such as real estate, may be growing faster than inflation, core and total CPI may not reflect this relatively higher growth rate since these measures of inflation consider prices across the entire economy. Because the narrow focus of an inflation-targeting framework requires the Bank of Canada to focus on total CPI, rather than on prices in a particular segment of the economy, monetary policy in this case would be unable to restrain price increases in the housing market. 4 ALTERNATIVES TO AN INFLATION-TARGETING REGIME 4.1 DECREASE THE INFLATION TARGET Some commentators argue that price stability, or a situation of zero inflation, would improve the current inflation-targeting regime in Canada, since even a low rate of inflation such as 2% contributes to an erosion in the value of Canadian money over time. The Bank of Canada estimates that total CPI is biased upwards by approximately 0.6% annually; 8 therefore, a goal of price stability would aim for a 0.6% increase in total CPI annually. A number of commentators have proposed that the Bank of Canada decrease its inflation target from 2%, which is the midpoint of the current 1% 3% range, to either 1% or 1.5%. 9 LIBRARY OF PARLIAMENT 4 PUBLICATION NO. 2011-111-E

4.2 BROADENED MANDATE TO MITIGATE THE EFFECTS OF ASSET BUBBLES The recent global financial and economic crisis has shown that price stability does not necessarily guarantee economic stability and well-functioning financial markets. Consequently, some commentators believe that the Bank of Canada s mandate should be broadened to enable consideration of asset-market stability in the setting of the target for the overnight rate. With this modification, if the Bank believed that assets prices were rising higher and more quickly than normal economic growth would suggest should be the case, it could increase the target for the overnight rate more quickly than inflation targeting would dictate in order to mitigate price increases in asset markets. 10 While a number of commentators agree that the Bank of Canada should have some mandate regarding financial stability, there are concerns that the sector-specific nature of asset bubbles may mean that monetary policy is too broad an instrument to be useful in reducing the prices of particular assets without causing undue harm to the rest of the economy. While the solution to this policy dilemma is unclear, the current governor of the Bank of Canada has suggested that, while there is a need for policy tools to address asset price bubbles, the nature of these tools and the manner of their implementation are unclear. 11 4.3 PRICE-LEVEL TARGETING Price-level targeting is similar to inflation targeting in that both approaches establish targets for a price index, such as total CPI. However, while inflation targeting is forward looking, 12 price-level targeting takes past years into account when establishing inflation targets. For example, if the price level were to rise 1.5 percentage points above the pricelevel target in a given year, the Bank of Canada would set its inflation target in subsequent periods in a manner that would return the price level to its original target. In this way, rather than trying to achieve a constant inflation target each year, the Bank of Canada would attempt to ensure that, in the long run, inflation on average is at the targeted rate. Implementing a price-level targeting regime could be beneficial. For example, with this approach, individuals would have greater certainty about the value of their money in the long run, since deviations from the inflation target would be reversed in subsequent years, unlike the current inflation-targeting framework where deviations are not corrected and could become sizeable in the long run. However, some commentators consider a price-level targeting framework to be relatively more difficult to communicate to the public, since it is more complicated than a simple 2% inflation target annually. As well, evidence of the success of pricelevel targeting is limited, since the only country to implement such a policy was Sweden in the 1930s. 13 According to a Bank of Canada representative, although there has been much research on the topic of price-level targeting since 2006, more research is needed before the Bank of Canada would recommend such an approach. 14 LIBRARY OF PARLIAMENT 5 PUBLICATION NO. 2011-111-E

In announcing renewal of the inflation-targeting agreement between the Bank of Canada and the federal government, the Minister of Finance said: At a time of continuing global economic uncertainty, it is more important than ever to provide a 15 stable economic environment. The 8 November 2011 agreement renewed the 2% inflation target, the midpoint of the 1% 3% target range. 16 A joint statement by the Bank of Canada and the federal government noted, however, that [t]he Bank will continue its research into potential improvements in the monetary policy framework. Before the end of 2016, the Government and the Bank will review the experience over the period and the results 17 of the research and determine the appropriate target for the years ahead. NOTES * This publication in an updated version of a 2007 paper prepared by Philippe Bergevin, formerly of the Library of Parliament. 1. Total CPI is a measure of changes in prices. To calculate this measure, Statistics Canada compares the retail prices of a representative basket of goods and services at two different points in time, and calculates the percentage change in the price of the basket. 2. Inflation-targeting agreements have been signed in 1991, 1993, 1998, 2001, 2006 and 2011. 3. In the short run, much of the change in the total CPI is caused by temporary fluctuations in the prices of such components of the basket of goods and services as fruit and gasoline, as well as in indirect taxes. For this reason, the Bank of Canada uses a core measure of CPI inflation, called core CPI, as an indicator of the underlying trend in inflation. This core measure excludes eight of the most volatile components of the basket and adjusts the remaining components to remove the effect of changes in indirect taxes. 4. Core inflation rose above 3% in November 2002 and reached 3.15% in January 2003 before returning to the target range in February 2003. Core inflation fell below 1% in February 1999, September 2000 and, most recently, February 2011. 5. Low inflation rates are usually preferred to low deflation rates, since decreases in prices associated with deflation generally lead to lower production, which in turn can bring about reduced wages, a situation that people are reluctant to accept. 6. Mark Carney, Governor of the Bank of Canada, Inflation Targeting in a Global Recession, Speech delivered to the Halifax Chamber of Commerce, Halifax, 27 January 2009. 7. The three key instruments that the Bank of Canada identified for conducting monetary policy at the effective lower bound are: conditional statements about the future direction of policy interest rates; quantitative easing, which involves the creation of central bank reserves to purchase financial assets; and credit easing, which includes outright purchases of private-sector assets. See John Murray, Deputy Governor of the Bank of Canada, When the Unconventional Becomes Conventional: Monetary Policy in Extraordinary Times, Speech delivered at the Global Interdependence Center, Philadelphia, 19 May 2009. LIBRARY OF PARLIAMENT 6 PUBLICATION NO. 2011-111-E

8. The Bank of Canada has outlined four sources of bias in total CPI: a commodity-substitution bias, since consumers sometimes choose to buy less expensive products when the cost of the product that they usually purchase increases but the basket of goods and services is updated by Statistics Canada only once every four years; a new-goods bias, which arises when prices of the products in the current basket decrease due to new products coming onto the market; a quality-change bias, which occurs due to price changes resulting from changes in quality; and an outlet-substitution bias, which arises due to a shift in market shares from high- to low-priced retailers. See Bank of Canada, Measurement Bias in the Canadian CPI, Backgrounders, 2010. 9. Angelo Melino, Moving Monetary Policy Forward: Why Small Steps and a Lower Inflation Target Make Sense for the Bank of Canada, C.D. Howe Institute Commentary, No. 319, January 2011. 10. Jack Selody and Carolyn Wilkins, Asset-Price Misalignments and Monetary Policy: How Flexible Should Inflation-Targeting Regimes Be?, Bank of Canada Discussion Paper 2007-6, June 2007. 11. Mark Carney, Governor of the Bank of Canada, Some considerations on using monetary policy to stabilize economic activity, Speech delivered to a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 22 August 2009. 12. Forward looking refers to the notion that the policy is only concerned with inflation in the future, rather than with reversing past deviations from the target. 13. John Murray, Deputy Governor of the Bank of Canada, Re-examining Canada s Monetary Policy Framework: Recent Research and Outstanding Issues, Speech delivered to the Canadian Association of Business Economics, Kingston, Ont., 24 August 2010. 14. Ibid. 15. Department of Finance Canada, Government of Canada Renews Inflation-Target Agreement with the Bank of Canada, News release, Calgary, 8 November 2011. 16. Ibid. 17. Department of Finance Canada, Joint Statement of the Government of Canada and the Bank of Canada on the Renewal of the Inflation-Control Target, 8 November 2011. LIBRARY OF PARLIAMENT 7 PUBLICATION NO. 2011-111-E