Moving target

It's all go at the Bank of Canada these days.  Fresh from announcing the establishment of its new online Financial Stability Hub, the Bank has revealed that it is re-examining the entire basis of its monetary policy framework, which comes up for renewal in 2021.  This press release summarizes the Bank's preliminary thoughts and contains a link to the full speech by Senior Deputy Governor Carolyn Wilkins.

By way of background, the Bank of Canada has based its monetary policy around a 2 percent inflation target for almost three decades. The policy is set via an agreement between the Bank and the Federal Government that is reviewed and updated every five years. This agreement comes up for renewal in 2021, and Ms Wilkins' speech makes it very clear that the Bank is looking for much more than cosmetic changes this time.

As the press release indicates, lessons the Bank has learned in the wake of the financial crisis have led it to believe that a wholesale review is necessary.  There are two key factors: first, the Bank's estimates of a "neutral" rate of interest is much lower than it was before the crisis; second, the fact that nominal rates of interest may be lower in the future than they were historically may lead to excessive risk taking (read: borrowing) by households and businesses.

The problem with the lower neutral rate of interest is that it implies that the Bank has much less room to provide conventional forms of monetary stimulus when crises hit.  If, as the Bank currently believes, the neutral rate is in a range of 2.5-3.5 percent, it has very little leeway to cut rates unless it moves into negative territory, something it has avoided until now.

As for excessive risk taking, it is tempting to suggest this reflects a too-narrow view of inflation on the Bank's part.  It has used all kinds of inflation measures over the years, including its current trio of core indices, but these have all related to consumer prices in one way or another.  Its conception of the neutral rate is likewise driven by its target for inflation at the consumer level. It has become apparent in the past two decades, and especially during the financial crisis, that tame consumer prices do not necessarily mean that monetary policy is correctly calibrated.  The financial crisis was driven by run-ups in asset prices that central banks, led by the Greenspan Fed, chose largely to ignore.

Ms Wilkins' speech is explicitly intended to start a debate on the issues, and to get things going she lays out some of the alternatives being considered by the Bank. There have been suggestions in many countries that a 2 percent target is too low; would 4 percent perhaps allow more policy flexibility?  Ms Wilkins notes that such a step would be hard on those living on fixed incomes, an important consideration as populations age, and could backfire if it triggered concerns that the target, once moved, could be subject to repeated change.

Other possibilities outlined by Ms Wilkins would require more drastic change.  They include price level targeting; an explicit dual mandate, requiring the Bank to hit targets for both prices and output; and nominal GDP targeting.  Each of these brings its own problems, not the least being that they would be much harder to explain to the general public than the present (deceptively) simple target.

Not, of course, that there's anything new about that. Ms Wilkins notes that average inflation since the 2 percent target came into effect in 1991 has been "pretty darn close" to the desired level.  However, I would wager that if you stopped Canadians at random on the street and asked them what the current inflation rate is, not one in ten would give you a figure lower than 5 percent, and many would insist stridently that it's a whole lot higher than that.  Good luck changing that, Ms Wilkins!