Get tough on inflation, BoC told

The Bank of Canada should rethink its inflation targets, focusing on maintaining stable prices at a much lower level, according to a study released by the C.D. Howe Institute entitled How Flexible Can Inflation Targeting Be? Suggestions for the Future of Canada’s Targeting Regime.

Hailing the Bank’s inflation-targeting regime as a success, Thorsten V. Koeppl, assistant economics professor at Queen’s University, calls for a fine tuning of the system when it comes up for review in 2011.

The Bank of Canada currently has a target band for the inflation rate centred on 2%. The report recommends that the Bank should aim lower, using 2% as the cap on a band running as low as zero percent.

“A general consensus has emerged in the academic literature that the overriding goal of monetary policy should be low inflation and that any persistent deviation from a long-run average level of inflation close to zero will lead to negative consequences for the economy,” Koeppl writes. “Economists tend to agree that expansionary monetary policy cannot increase the trend of output or employment in the long run but instead will result in higher inflation and often lower growth for the economy.”

Such a mandate would trigger Bank policy reactions as soon as the inflation rate threatens to breach the band, both on the upside and the downside. Having such a hard target would lend transparency to policy formulation and “more firmly anchor the public’s inflation expectations,” Koeppl writes. It “might also lead to the Bank taking a more proactive role in response to financial market developments.”

While the report calls for a lower, firmer inflation band, it also calls for greater policy flexibility for the Bank in fighting inflation.

While a sudden shock to the system could result in a temporary spike in inflation, this should not necessarily result in correspondingly large policy shifts. The Bank must be permitted flexibility in determining the suitable time horizon to achieve its target following a large shock.

Some cases may call for an immediate response, while others may be corrected by consumer activity over a longer period.

“Should the Bank resort to such event-contingent flexibility, it should offer an explicit justification for doing so and commit to a specific path for returning to the target,” Koeppl writes.

The time horizon over which inflation is measured must be clearly communicated to the public and, therefore, the market, to further enhance transparency and avoid surprise policy shifts.

Of course, the Bank has concerns beyond its core mandate of mitigating inflation. On August 25, Bank of Canada Deputy Governor Timothy Lane said the Bank would not allow a rising dollar to choke off economic growth, hinting none-too-subtly that the Bank would move to clip the loonie’s wings if it continued its ascent.

While this is a far cry from advocating a currency peg, it does indicate that the Bank can be swayed from its inflation mandate.

“Targeting (or even pegging) the exchange rate necessarily sacrifices some monetary independence,” Koeppl writes. “Monetary policy then cannot react to domestic inflation pressures but instead must adopt, to a large degree, the policy stance of the country against whose currency its own is pegged. This compromises price stability if there is an inflation bias in that country.”

The problem is exacerbated by an economy prone to large, periodic swings in the real exchange rate. Reacting to such movements can come at a cost of pursuing other goals, such as inflation fighting. Remaining focused on inflation could even help to correct exchange rate problems.

“When the exchange rate moves, there are direct and indirect effects on aggregate demand,” writes Koeppl. “Hence, concentrating exclusively on inflation and aggregate demand forces monetary policy to evaluate the factors that cause exchange rates to change.

“Even if there is a trade-off with stabilizing output, controlling inflation should remain the overriding goal of monetary policy.”

To read the report, click here.