The Inflation-Control Target

So, the 2% inflation target has been renewed as it now stands. (Take that, House of Commons Finance Committee, which is holding hearings on the issue next week.)

The background report from the Bank of Canada is pretty self-congratulatory, though it does somewhat revise the current regime to underline the point that monetary policy also needs to take financial stability into account. While stressing that regulation (credit controls, direct regulation of financial institutions) should be the first line of defence against potentially destabilizing private credit bubbles, the report underlines that central banks may have to take more than the rate of inflation into account when setting interest rates.

But the word “unemployment” is barely to be found in the report. This reflects the conventional wisdom that a 2% inflation target is quite compatible with low unemployment so long as the labour market is “flexible.”

The left sometimes under-estimates the costs of inflation, which undermines the purchasing power of wages and of savings for retirement. We need to remind ourselves that the stagflation crisis of the 1970s discredited the Keynesian consensus supporting full employment and opened the intellectual and political door to neo liberalism. I don’t take particular issue with the idea of an inflation target, though 2% is probably too low since a very low inflation target can impede nominal wage adjustments in response to economic shocks, and since it effectively forecloses negative real interest rates as a way of boosting demand and jobs.

That said, I do think that the central bank should have a dual mandate to pursue both a reasonable inflation target and a target for low unemployment, as is the case in the United States, as was the case in Canada, and as is still implied in the preamble to the Bank of Canada Act itself.

“WHEREAS it is desirable to establish a central bank in Canada to regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada.”

Lars Osberg recently reminded us that setting a target for inflation but not for unemployment predisposes the central bank to focus one-sidedly on the former. If the Bank of Canada only has an inflation target, then it will likely hit it pretty consistently (as it has).

But Lars argues that a rather wide RANGE of unemployment rates may be consistent with stable inflation. Thus there will be a significant and ongoing cost attached to minimizing inflation risk as opposed to trying to balance inflation and unemployment risk. Before the recession, we may have been able to push the national unemployment rate down to 5% without pushing inflation above 2%, but the Bank of Canada never tried. The cost of not pushing for lower unemployment is to be counted in terms of lower output, and also lower potential output. He also emphasizes the very real human costs of unemployment as identified in recent research on happiness and well-being.

I guess no one over at the Bank of Canada feels a need to respond to such heresies.


  • How the hell can you post this garbage when the government has been hogtied from using the bank of canada to pay down the national debt? As well as allowing private banks to issue and control the currency.

    Any talk of the bank of canada being on the side of workers is bullshit capitalistic propaganda and the people on this blog need to stop swallowing it.

  • I won’t disagree that inflation has costs. But as to retirement, we should be increasing the public component of retirement savings anyway, which would make that less of an issue.

  • Also, it could be argued that the Bank somewhat violated the terms of its agreement with the Government during the 1990s given that inflation was kept below its stated target of two percent during most of that period. Pierre Fortin did some good work on this.

  • So, Andrew, would you support a Nominal GDP level path 5% growth target, as one way to implement a “dual mandate” and interpret the Bank of Canada Act? You might find yourself in some dodgy company 😉

  • Hey Nick what is the natural NGDP growth rate?

  • Andrew wrote:

    “We need to remind ourselves that the stagflation crisis of the 1970s discredited the Keynesian consensus supporting full employment and opened the intellectual and political door to neo liberalism.”

    To my mind this is wrong headed. We did not have anything near full employment and the lefts preoccupation with full employment opened the door to supply side arguments because they argued that a focus on the supply side would restore full employment without inflation.

    And it nearly did in spades to such an extent that Nick is now toying with targeting NGDP. Nice work.

  • Mike, most advocates of deficit monetization by the central bank do recognize an inflation constraint.

    Not sure I get your point Travis. The golden age in Canada might have fallen a bit short of full employment for men, but there was an extended period of low unemployment with low inflation.

    To be clear, the failure of the left to deal with inflation was political rather than intellectual. The alternative to a turn to the right was for labour to internalize the need for wages to grow in line with productivity, in return for much greater social control of the investment process to raise productivity and indeed work on the supply side. That is basically what the Meidner plan was about in Sweden, and whAt Benn was advocating in the UK.

  • Ok your take and mine are different enough to warrant a bear. A couple of points though:

    First, I find it hard to get to a wage push theory of inflation in the context of increased LF participation by women and teenagers.

    But forgetting that, the data I have looked at shows productivity leading wages and then a reaction to that in bargaining. At the very least your model needs to be of price makers in the factor markets and price makers in the product markets. So some need for a profit push story of inflation too.

    If that is correct then you needed both capital and labour to internalize the need for both profits and wages to track productivity increases.

    “That is basically what the Meidner plan was about in Sweden, and what Benn was advocating in the UK.”

    Yes and in both cases capital said F@#$ off to workers particularly in the case of the UK. Globalisation to my mind is about capital removing the need to make inter class productivity pacts of the type that typified the postwar boom.

    So yes as you say a political problem but different than the one you have identified.

  • Travis. I would agree we have not seen wage push inflation since the neo liberal ascendancy. To the contrary, real wages have stagnated, and lagged productivity. But the possibility has to be considered if we want the central bank to push hard to lower unemployment. That is why I think it is worth considering a dual mandate for the Bank.

  • Ok lets play a game of ordinal fantasy island.

    I would prefer:

    A central bank which was responsible to the people which had a mandate to ensure full employment within some flexible regime of price stability.
    Subject to:
    1) the near total socialization of the investment function and;
    2) a commitment that productivity gains were exploited in terms of an increase in the quality of consumption and a decrease in work time within the context of heavily redistributive fiscal regime

    Second best:

    A democratically controlled central bank which had as its first priority full employment and a secondary concern with price stability and where productivity gains were taken in the form of an increase in the quality of consumption and a decrease in working time within the context of heavily redistributive fiscal regime.

    Third best:

    A democratically controlled central bank which had full employment as its primary concern and price stability as a residual (but real) concern. Within the context of heavily redistributive fiscal regime.

    Fourth best:

    An independent central bank with full employment as its primary objective and price stability as its second objective. Within the context of heavily redistributive fiscal regime.

    Fifth best:

    An independent central bank with a dual mandate. Within the context of heavily redistributive fiscal regime.

    Sixth best:

    An independent central bank with the bloody minded myopic mandate of price stability. Within the context of heavily redistributive fiscal regime.

    non starter:

    An independent central bank with the bloody minded myopic mandate of price stability. Even if it did target NGDP.

  • NGDP = P.Y

    Y=F(employment) , F'(.) > 0

    NGDP = P.F(employment)

  • Maybe I am missing something.

    When full employment is considered to be an equilibrium natural rate (level) of employment there is nothing stopping a nominal target from being subservient to stability in the price level. In world where the central bank targeted NGDP growth of 3% but inflation was running 4% the level of F would be pathetic.

    To my mind the central bank can only pick one target and make the rest of the aggregates subservient to it. Targeting NGDP just makes the whole thing even more opaque.

    I am sure my confusion stems from my lack of subscription to ratex.

  • Hi Nick, I would love if you could write in English rather than models more often, please. I find your posts interesting, but only when I understand them.

    Andrew, you seem to be favoring a wage-push theory of inflation in the 1970s. As an alternative you seem to offer Trudeau and Galbraith: “The alternative to a turn to the right was for labour to internalize the need for wages to grow in line with productivity…”

    But wage-push is only part of the Canadian picture, in my view. What about the unpegging of the dollar in 1970? The oil shock? The general crisis of overaccumulation? The need to offset the subsequent devaluation through printing money? etc.

    I would personally attribute inflation in the 1970s to the general crisis of overaccumulation, a la Marx.

    The joy of inflation targeting, coupled with Central Bank Independence, is that it doesn’t have to factor unemployment into the equation…or anything else, for that matter. It follows that the inflation target should be done away with. Alternatively, the operating band could likely be moved way up the scale without a serious negative impact upon wages, savings and so on.

  • “I would personally attribute inflation in the 1970s to the general crisis of overaccumulation, a la Marx.”

    This is the Brenner thesis and I have never understood how you get overaccumulation in the means of production to be the cause of inflation. Normally we consider inflation to be caused by an increase in purchasing power which is greater than the growth in the means of production when we are already at full capacity utilisation.

    In direct terms, how do you get overcapacity to generate inflation and unemployment?

  • just a short comment on inflation- we are cyurrently at a point that will be a pivotal point in determining inflation in 5 years. If during this downturn, excess capacity is shuttered, i.e. permanently removed form the productive sphere, then we will be faced with a lower bound for inflation targeting in some future sense. THis assumes that productive investment does not synchronize with demand growth. (not sure whose thesis you call that). However, turning off the speculative casino would help push a lot of the capital accumulation , i.e. that which is caught up in financial investments. Otherwise we could see a whole lot of unnecessary shuttering of production.

    This gets back to the whole notion of stimilative needs by both the public and private sector to keep the current inflation wall from moving in, and expanding it outwards. THis of course goes against business sense, why would you build more capacity when the current is already unused. Well one day, potentially on another planet where the economy actually is not fixated on short term profit generation, there could be growing demand that that capacity will be needed to say, oh I don;t know, say feed the world’s 1/3 without food!?

    By the way, inflation makes no sense. How can we have inflation when we have so many unment demands and idled resources? This my friends is the ultimate question that an economist’s must stand up and answer and it will be capitalism in it’s current forms ultimate undoing.

  • Hi Matthew. Sorry. let me explain in English.

    At one extreme you have a central bank that targets inflation only. At the other extreme you have a central bank that targets employment only. NGDP targeting is (roughly speaking) halfway between those two extremes. It’s a compromise. Roughly speaking, it’s like a dual mandate (inflation and employment), except you add the two mandates together into one single mandate.

    With a little algebra, you can show that: NGDP growth rate = inflation rate + growth rate in employment + productivity growth rate.


    Krugman points out an arcticle that speaks to what I was referring to above authored by two guys Jesús Fernández-Villaverde Juan F Rubio-Ramirez

    Interesting points they make

    “Two questions remain open. First, why do we emphasise the importance of increases on future output when we are at the zero lower bound? Should not a government want to increase future output regardless of whether we are at the zero lower bound? Yes, it should if the increases are free. However, these increases are usually costly, either in pure economic terms (we need to build a new bridge or learn a new technology, or more competition may reduce incentives to carry out R&D in a model of endogenous growth) or politically (the reforms that yield higher productivity decrease the rents of some groups). But when we are at the zero lower bound, these structural reforms have a higher-than-normal rate of return. Not only do we obtain more consumption tomorrow, we also fight the demand problems today. Outside the zero lower bound, increases in future productivity are undone, in terms of consumption today, by an increase in the interest rate that ensures market clearing in the first period. At the zero lower bound, that effect disappears and hence consumption today also rises. Thus, reforms that would be too expensive either economically or politically in normal times can become desirable when the interest rates are zero.

    Second, would the wealth effect be important enough? Unfortunately, we do not have a firm answer to this question simply because we have not been in this situation in recent decades. Our prior is that countries such as Spain also have a sufficient number of “low-hanging fruits” in terms of supply-side reforms that can be easily snatched. Anyone familiar with the deep inadequacies of the Spanish labour market or with the surrealistic regulations in many sectors of its economy cannot but forecast considerable gains out of structural reforms (as occurred in the past, such as in 1959, 1985 or 1993–95, when previous structural reform packages were passed). One interesting aspect of our argument is that it does not depend on a permanent change in the growth trend of the economy, something that after 25 years of endogenous growth theory is still a chimaera, but only on the possibility of increases in the level of output. Thus, we are much more sanguine about the role of supply-side policies in Eurozone countries than in the US or the United Kingdom where, arguably, there are fewer productivity gains to be had.

  • so they do get my point, during these times, you can build a “needed bridge to somewhere” or some other targeted asset that will produce future value, and it will be a whole lot more affordible right now. Why, 3 majors reasons see if you can get them without peeking:

    1) idle assets and employment can be used productively

    2) interest rates are low so it is a whole bunch more cost effective to invest now

    3) no real worries of crowding out the private sector, they are too busy sitting on their hands- uh I mean piles of cash.

    there most likely a few more reasons but on a Sunday just before I put the young one in bed, is all I have time to think about.

  • sorry, for anybody who read the article on the link I posted, I should add, that I am not supporting the supply side third wayism they are toting as a panacea to our economic dilemna . In fact, like Krugman points out, I don’t see the logic. So we unleash pent up efficiencies in the production process, or somehow (magically it seems) one lowers market power of firms and hence recoup those lost rents, I am not sure how that solves the demand problem.

    Cheaper goods is not a solution for economies that had become to addicted to economic bubbles of ficticious weealth creation, the latest incarnation being the mortgage equity backed demand growth. How about we start with, say a modelled approach similar to the new deal, we take higher wages that grow over time and build a system around that.

    Productivity efficiencies sound a lot like more of the same, chase lower labour and enviro standards. And knocking out oligopolistic firm power over moarkets is like saying you want to destroy capitalism. Are these guys like communists or something???

    Lol gees we are getting desparate for a thesis to rebuke the liquidity trap and acknowledging it is declining demand that is our evil enemy. Untile we actuualt officially acknowledge the problem, I just do not see who we can get a legitimate solution through the political space of the economics.

    Austerity and the rest of it is like recommending we give more kryptonite to superman to fight lex luther.

  • Hey Nick,

    NGDP = C + G + I (X-M)

    With a little grade nine algebra it can be shown that the government can target NGDP growth. Given the government, unlike the central bank, can actually determine the aggregate level of investment and not just influence it (sometimes) why would want to use the central bank?

  • Hi Nick, Travis,

    Nick, thank you for the explanation! Really interesting. That is the first time I’ve come across the notion of a dual mandate (unemployment and inflation).

    Travis, you asked: “In direct terms, how do you get overcapacity to generate inflation and unemployment?”

    For the inflation side of your question, my answer is this: overaccumulation occurs when too much capital is produced in relation to opportunities to use that capital. This would normally result in a subsequent devaluation of commodities. However, our monetary system is no longer tied to material reserves. This allows the state to inject money into the economy as a means of offsetting devaluation. Depending on where this money goes, it may or may not result in inflation.

    For the unemployment side of your question, the devaluation that occurs following a period of overaccumulation may entail rising levels of unemployment, wage restraint and so on.

  • With every country trying to fight against inflation, I find the above arguments interesting. I agree with a lot that has been raise but I dnt agree that inflation has costs, inflation is increasing every day and blaming banks is not the solution. As for the government, I think it is trying to fight against inflation in all possible ways it can.

Leave a Reply

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