Cutting interest rates to increase inflation

There is a new line of thinking over at the Bank of Canada: rather than raising interest rates to maintain the inflation target at 2%, the Bank is now stating that it might have to cut rates (beyond the 25 bp reduction today and 50 bp a couple weeks ago) to maintain the target. From a central bank that in the last recession was all too eager to reduce inflation to zero, and as recently as last summer was blithely talking about shifting to price level targeting, this is quite the admission.

Check it out in today’s press release:

With excess supply projected to build throughout 2009 and lower assumed energy prices, inflationary pressures will ease significantly relative to the projection in the July Monetary Policy Report Update. Core inflation is now projected to remain below 2 per cent until the end of 2010. Total CPI inflation should peak during the third quarter of 2008, fall below 1 per cent in the middle of 2009, and then return to the 2 per cent target by the end of 2010.

… In line with the new outlook, some further monetary stimulus will likely be required to achieve the 2 per cent inflation target over the medium term.

Boy, am I glad I chose the variable rate mortgage a year ago; being an economist has saved me a few thousand dollars a year in mortgage interest. Interestingly if we turn back the Bank’s clock a year, it makes for an interesting contrast with today’s announcement:

Against a backdrop of robust global economic expansion and strong commodity prices, … the Canadian economy is now operating further above its production potential than had been previously expected. The core rate of inflation, which has been above 2 per cent for the past year, was 2.2 per cent in August. Total consumer price inflation fell temporarily in August to 1.7 per cent, having been above the 2 per cent inflation target since the spring. … [T]he Canadian economy is projected to grow by 2.6 per cent in 2007, 2.3 per cent in 2008, and 2.5 per cent in 2009.


  • I don’t understand your point. A year ago, the Bank’s measure for the output gap was positive; now it’s negative.

    I don’t really have a problem with a central bank that changes its policy stance when conditions change.

  • I do given have a problem and agree with Marc. Come on Stephen you actually actually believe all that BOC They should have been lowering rates a long time ago, the conditions have just went from bad to worse.

    WItht he commodity bubble bursting and the economic upheaval coming from our southern neighbours, we could very well be talking about deflation in a very short time. Having an almost exclusive inflationary discourse that the BOC has for the last while and then to suddenly switch to deflationary spirals, is not something that happens in the time frame we are talking about.

    And that is with all the information they have and the armies of policy wonks to guide their policy. The problem is, they are too often guided by politics than economics.

    If you don’t understand that then it is time you and I went behind the shed and had a talk.

    That is the central point- do you get it now?


  • I just think it is remarkable that the Bank would talk about cutting rates to increase inflation. Not that it would necessarily work. And not that inflation targeting is the optimum monetary policy rule in my opinion.

    But Mark Carney has certainly shown some guts to make a statement contrary to the “tough on inflation” the Bank has taken in years past. So that’s a good thing.

  • Gordon,

    It is the height of naiveté to be talking about the output gap with a straight face. I will grant that theoretically I can imagine it existing but certainly not in the form of forms that haunts your skull.


    You know very well that what haunts the BOC is the specter of disinflation. And that the Irony is veil of tears. We are not Japan: cut interest rates so that they are in real terms negative. Repeat we are not Japan. Worry not. If they succeed in re-inflating the bubble then we get back to being inflation hawks. The real point is that none of these antics are being motivated by a concern for real labor markets.

  • The Bank’s policy isn’t always lower inflation; it’s a policy of 2% inflation. When the output gap is negative, it means that the Bank believes that inflation is going below target, so interest rates can be reduced.

    That’s pretty much the policy that the Bank has been following for more than 15 years. No guts were required to make that call.

  • Gordon,

    Since when was the target a suggested minimum? That is just revisionism of the most opportunistic kind. 2% has always been about the maximum tolerable limit: a ceiling not a floor. Marc is right, it is curious, and it it is not about guts it is about a shifting ideology. 5% inflation would be tolerated over the short term if it were deemed necessary. That is, it is about the distributional origins of inflation not about inflation per se.

  • If you don’t understand that then it is time you and I went behind the shed and had a talk.

    Yes, Paul. Because physical intimidation of scholars for saying what they believe has always worked so very well in the past.

  • Stephen, show me any evidence that the Bank has ever tried to use monetary policy to increase inflation.

    In fact, in spite of the ostensible 2% rule the actual inflation rate has often been lower.

  • Do you two work in the same building or something? Otherwise, Stephen, carping at Paul for his comment doesn’t seem much more than a ridiculous and heavy-handed “Gotcha!”

    One would think you actually _had_ something to worry about . . . .

  • Stephen

    I was only suggesting verbal discussion behind the shed. That is, lets get to the real bottom line of what is going on. (you never heard of that, i.e. take off the gloves and have a real debate not some convoluted massaging of reality that seems to have been raised by your point on the BOC).

    Sorry I do not practice intimidation tactics that you suggest, but I do practice logical debate based on facts and reality. And that was all I was underlining in that comment.

    Relax, we are just debating here, nothing more.

  • I’m glad this conversation did focus on debating the details, which is useful. ‘Sheds’,’ilk’, and other kinds of insults still do nothing for real dialogue. Yes, everyone is stressed out, but please…deep breaths..

  • just saw that, thanks Paul for clarifying.

  • Leigh,

    Since when did using words in English that have their origins Germanic as opposed to Latin constitute an insult? Not that I am some kind of Anglo-Frisian purist or anything it is just that I find the idea that the Germanic version is somehow less scientific or neutral than the Latin somewhat culturalist to say the least. But then again my ilk does not take offense that easily.

  • Stephen, show me any evidence that the Bank has ever tried to use monetary policy to increase inflation.

    Let’s go back to 1996:

    Inflation was below target

    The Bank’s measure of the output gap was negative

    And the Bank cut interest rates

  • Oh, and the same story happened again in 2001.

  • Gordon,

    Are you talking about the number of strikes at laval you have failed to support or the policy of the BOC?

  • Do you intend to scab during reading break?

  • Stephen,

    I just looked through all the rate announcements for 2001 and 2003 and see nothing like what I quoted above. But perhaps I’ve missed something – got any links and/or quotes?

  • Hi all,

    Well, it turns out that both Stephen and Marc are right. Stephen is right insofar as the bank of Canada has long claimed that it operates monetary policy “symmetrically,” caring as much about inflation below target as above target. I can still remember Serge Coulombe, my macro teacher at Ottawa University, telling us this in 1997 (to quiet one particularly unruly lefty student, i.e., me). David Dodge also stated it on a number of occasions while presenting to the House of Commons Finance Committee. I think even Thiessen made utterances to that effect. If anyone needs them, I can dig up the supporting citations.

    THAT SAID, Marc is right in that this is mostly a rhetorical claim. To substantiate this point, I would urge readers to consult that noted left-wing institution, the IMF, which published a fascinating study titled “Why is Canada’s Price Level So Predictable?” in which they find, a la Marc, that Canada’s inflation rate since 1994 has been consistent with price-level targeting, not inflation targeting, i.e., more concerned with inflation above-target than inflation below-target. The reference is:

    Finally, on the issue of capacity, it is a notoriously fuzzy one that the Bank has, in the past, defined in the kind of classic circular logic that defines so much of modern mainstream economics (capital controversies anyone? — sorry, couldn’t resist the stab): how do we know we are above capacity? Because inflation is above target. And don’t get me started on the Bank’s unwillingness to talk publicly about its NAIRU estimates, which figure into (more concrete) versions of capacity estimation than the aforementioned method. Transparency my arse.


  • I don’t understand the need to invent Byzantine theories about what the Bank does and why. The policy is easy enough to understand, and the Bank has gone to great lengths to explain it. And as I just noted, the Bank’s actions are consistent with its stated policy. The Bank has in fact initiated at least three rounds of interest rate cuts without disavowing the inflation target.

    This really isn’t all that complicated. I mean, it’s all very well to fight the good fight of 1992 and to vociferously denounce John Crow and all his works, but this is 2008. It’s time to move on.

  • Stephen,

    I don’t think you’ve read the IMF paper. It shows, quite conclusively, that the Bank of Canada has tended towards favouring inflation below 2% despite rhetoric to the contrary. This is a strictly empirical matter which, I would have assumed, was relatively uncontroversial. In the interest of furthering fair-minded discussion, please explain the nature of your disagreement with the IMF research.

    As for the capacity issue and supposedly Byzantine theories, there is considerable — even mainstream — literature that shows how, in fact, these issues are not as simple as you make them out to be. See, for example, some of the work by that other radical lefty, Benjamin Friedman of Harvard U. I would be happy to share this and other information offline if you are interested in pursuing this discussion.



  • Hi! This is the kind of discussion which makes me a devoted (if admittedly highly inexpert) reader of this blog.

    It seems to me that, while the Bank may indeed have gone to great lengths to explain its putative inflation-targetting policies, with the exception of Governor Carney’s recent comments, not only has no governor in the last twenty years spoken of any need to reinflate the economy, there appears to be only one occasion when one (Thiessen) actually intervened to do so. This was, of course, in 1997 and into 1998, when, for over a year, Thiessen permitted not only nominal but real interest rates to drop, almost unprecedentedly, below U.S. rates. However, this appears to have been an urgent measure to forestall deflation, for Thiessen’s anti-inflationary intervention in 1995 and Martin’s cuts in 1995 and 1996 had combined to drive the annual change in the CPI below one percent by 1998. Given how low inflation was from 1995 to 1999 (consistently well-below the Bank’s target, as Jim Stanford has documented), it is absurb to view Theissen’s policies as somehow being directed at meeting the Bank’s target; the only rational explanation is that they were a desperate measure to forestall policy-induced deflation. So Governor Carney deserves some credit, since every other Governor’s commitment to the target was clearly disingenuous, at best.

    YEAR Annual Inflation (CPI)
    1995 2.2
    1996 1.6
    1997 1.6
    1998 0.9
    1999 1.7

  • Arun: Yes, I did read it, but I don’t see why you think it’s that big a deal. The difference between inflation targeting and price level targeting is that the latter doesn’t ‘forgive’ temporary deviations above or below the inflation target. Given the deviations we’ve seen from the target we’ve seen over the past 15 years, it’s hard to see why the distinction matters very much.

    Moreover, I don’t see how it counters my main point: the Bank is pretty clear about how it conducts monetary policy, and its observed conduct of monetary policy is pretty consistent with its announced policy. When inflation goes above (below) target, and if the output gap – a series the Bank publishes – doesn’t suggest that inflation will return to the target on its own, the Bank increases (reduces) interest rates.

    I can’t think of any episode that contradicts this story.

    Just out of curiosity, is there anyone out there who still thinks that the Bank has a policy of high interest rates to fight inflation?

  • Depends what the BOC thinks is the origin of inflation. But interest rates are not the only mechanism they have to squeeze the life out of labour markets. So the real question is does the BOC still think labour markets should do the heavy lifting in the war against inflation? As long as the NAIRU is still in their theoretical tool box how could one answer in the negative?

    “Just out of curiosity, is there anyone out there who still thinks that the Bank has a policy of high interest rates to fight inflation?”

  • Perhaps Stephen was concerned when I said elsewhere that we paid high interest rates to private bankers in the ’80s ‘and continuing’. To clarify, the ‘continuing’ referred to the debt amassed because government borrowed from private bankers during this period, at high interest rates, instead of from the Bank of Canada, and people like Flaherty continue to insist that debt be paid off while still avoiding use of the Bank of Canada for government needs. Even now the government could borrow money from the BofC, with interest paid going back into the government-owned coffers of the BofC. Measures could be introduced so that these loans are amortized over the lifetime of, say, a green public infrastructure or a needed service project. Certainly they’ve introduced lots of other measures to the BofC Act giving more flexibility in picking up the trash of the players who caused the crisis. They should be flexible in providing funds for critical public projects.

    To hear Flaherty preaching about being ‘responsible’ while he hypocritically maintains policies designed to funnel public dollars to his crony private banking friends, especially when so many ordinary people are suffering in this crisis, is simply enraging.

    Hopefully Flaherty’s and the BofC’s bailouts/ backstops/ bank loan guarantees/collateral aquisitions of ABCP, corporate bonds, ‘and any other financial instruments’ doesn’t load the government-owned BofC with too much trashy private risk, leading to a call for a merger with the Fed or ECB in future- we’d lose our publicly-owned central bank to those which are privately owned.

    So enough already with the financial panic, filled it seems with hedgers now forced to sell. Enough with the freebies to banks. Let’s start dealing with the real security concerns of residents. Let’s start funding good public pensions, put the funds back in public services that have been stolen over the last two decades, let’s use the Bank of Canada as it apparently was used after the war-for public needs, and let’s ditch the investor clauses in the trade deals that are killing our jobs.

    thanks for listening,L

Leave a Reply

Your email address will not be published. Required fields are marked *