Bank of Canada Inflation Targeting
It was a ho-hum announcement, and I don’t know if it generated much media coverage in Canada or not.Â But last week the Bank of Canada and the Dept. of Finance announced another 5-year extension (to 2011) of the current inflation targeting regime (keep total year-over-year inflation within a point above or below 2 percent, using the core inflation rate CPIX as the more important guide for policy movements).
Here is the link for the Bank’s backgrounder on the issue, which is predictably self-congratulatory:
The Bank plans to undertake a big research program over the next couple of years, considering in particular whether it should reduce the target (perhaps to 0-2 instead of 1-3), or in fact target the price LEVEL rather than the inflation RATE.Â This latter move would be bizarrely dangerous: it would require the Bank to deliberately engineer deflation (or disinflation) to offset any “errors” in which actual inflation diverged from target inflation.Â (Example: suppose inflation overshot the 2% target for one year; the Bank would then need to engineer below-targetÂ inflation for one year to bring the price level back to its target.)Â Given that the Bank still relies on an underlying Walrasian model in which the value of low inflation is that it allows agents to make more informed general-equilibrium decisions and actions (thus leading to a more efficient GE solution), it would be a logical (though utterly impractical) extension of their logic to adopt price level targeting.Â The Bank will probably get big support for this possible change from conventional monetary theorists (David Laidler, et al.).Â We on the left had better be ready to push in the other way.
Apart from preparing to counter this potential tightening of the inflation target noose, I am frankly not quite sure what heterodox economists should say about targeting.
I accept that the costs of disinflation were huge.Â I reject the Bank’s view that something like 7 percent unemployment is “full capacity.”Â I also reject the implict assumption that changes in unit labour costs arising from excess tightness or slackness in labour markets are the main reason that inflation either rises or falls (and I think there is potential for some interesting empirical work into the link, or lack thereof, between labour markets and inflation in the recent Canadian experience — it’s one of the weaker links in the Bank’s logical chain of causation, in my view).Â I accept the argument that modest inflation can act as a valuable economic “lubricant” allowing for less painful adjustments in relative prices (including wages) — although I’ve never been convinced that you need more than 2-3% inflation to do this.Â I do not believe in a stable trade-off between inflation and unemployment (though obviously for different reasons than a Friedman or Phelps would propose), so I don’t believe we accomplish anything for the workers by simply allowing inflation to rise.
But now that we’re in a low inflation environment, however, it’s probably worth trying to stay there (with appropriate flexibility and balance).Â Has targeting been as successful as the Bank argues?Â Perhaps it has been helpful, although for alternative, non-Walrasian reasons.Â In some post-Keynesian and other heterodox models, inflation can become a “customary” variable: hanging by its own bootstraps, as it were, until some powerful force pushes it one way or the other.Â Targeting may create something a bit more tangible for that “customary” variable to stick to.Â This could be valuable if it helped to restrain inflationary pressures (arising from producers selling into buoyant product markets, as much as or more than workers trying to get higher wages in a tight labour market) as unemployment declines.Â Mark Lavoie was highlighting some of these issues in his very interesting presentation to the PEF macroeconomic session at the CEA meetings in Montreal last spring.
On the other hand, heterodox economists in Europe (like Malcolm Sawyer and Philip Arestis) have been extremely critical of inflation targeting over there.Â I wonder if it is targeting per se that has been the problem in Europe, or whether the general ossification of the European central bank and the particular circumstances of currency unification were the actual culprits.Â The U.S. continues to benefit from the most pro-active and flexible monetary policy in the world; their central bank, importantly, is not constrained by a formal target (though Bernanke is warm to the targeting idea, and we all know that the Fed has an inflation target of some kind in its back pocket — right beside the NAIRU that it also stores back there).
I’ll conclude with an open question.Â Is there a non-knee-jerk critique of inflation targeting that progressive economists can make in the Canadian context?Â Or should, in fact, we embrace targeting as one part of an alternative monetary policy regime (one that also featured an explicit commitment to full employment and a different underlying theoretical model about what actually causes inflation)?
Insights on this point are most welcome.Â I might even devote my next Globe column to this underexplored topic.