Go-slow approach usually best for fighting inflation

StatsCan’s announcement on Wednesday that it had miscalculated the consumer price index for the past five years could not have come at a better time, as it preceded the Bank of Canada’s Summer Review by one day. The focus of this quarterly review? Inflation.

It is common knowledge that any move by a central banker to control inflationary pressures will take time to work its way through the economy and have any impact on inflation. What is less commonly understood is just how long that lag is…or should be.

In an article contained in the Bank of Canada review, entitled Another Look at the Inflation-Target Horizon, by Don Coletti, Jack Selody and Carolyn Wilkins, the authors find an appropriate inflation target horizon to be between six and eight quarters — meaning interest-rate adjustments should be made with an eye toward returning inflation to its target over a time horizon of 18 to 24 months.

The Bank of Canada has an inflation target of 2%, the halfway point in its acceptable band of between 1% and 3%. The problem the Bank faces is that inflation does not immediately return to target because of frictions in the economy, such as wage contracts that adjust worker’s salaries to compensate for higher-reported inflation.

Any serious up-tick in inflation may require drastic measures to bring the rate back in line with targets, while lesser deviations from the target can be met with a more measured response. Each approach has its own advantages and disadvantages.

“A short horizon would be consistent with a vigorous change in interest rates in order to return inflation to target quickly, but could result in excessive volatility in interest rates and the real economy, since the lagged effects of vigorous interest rate changes need to be cancelled by subsequent actions in the other direction,” the report says.

The problem with such an approach is that it leaves the Bank little time to judge the effect of its actions. While a shock to the economy may be felt immediately, changes in interest-rate policy will unlikely have such an immediate effect on borrowing habits. The Bank would usually need to make smaller interest-rate adjustments to ensure it did not overshoot its target.

“A long horizon would be consistent with a more sluggish change in interest rates that could result in less real volatility, but would cause deviations of inflation from target to be more persistent,” the report says.

The researchers compared two models of the Canadian economy and subjected these models to various shocks, gauging the severity of the impact on overall output. They then applied various monetary policies to these models to find the optimal combination of both reduced volatility and a swift return to inflation targets.

“In most instances, the studies support the conclusion that the Bank’s policy since 1991, which has aimed to return inflation to target within a six-to-eight-quarter target horizon, remains appropriate,” the report concludes. “In rare cases when the financial accelerator is triggered by a large and persistent shock, it may be appropriate to take a longer view of the inflation- target horizon.”

Perhaps the most important lesson for central bankers is the power of their influence as a calming agent, based on their own credibility as an inflation fighter.

“One of the key determinants of the persistence of inflation in the economy is the credibility of monetary policy,” the report says. “If policy is highly credible, inflation expectations will remain well anchored to the inflation target over the medium term.”

Fortunately, the BoC and its governor, David Dodge, are generally regarded as credible, and Dodge is already one of the longest serving of the current central bankers.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com