Challenging Inflation Targeting

Every 5 years the federal Finance Minister updates the “marching orders” that guide the Bank of Canada and its conduct of monetary policy.  This process is the one opportunity for democratic oversight of the Bank, which otherwise is deemed to be operating “independently” of government — all the better to ensure that it has the authority to take away the punchbowl whenever the economic party gets going too energetically.

There hasn’t been a lot of public debate about the mandate renewal, which must occur by the end of the year.  The Bank itself has issued some obscure technical papers considering various fine points of its present inflation-targeting system (whereby it is instructed to keep inflation around 2 percent per year, plus or minus one point).  Most interesting is its consideration of an alternative price index to guide its actions: exploring the use of alternative measures (such as the so-called “common component CPI”) which supposedly better reflect underlying inflation tendencies than traditional indices (like CPI, which is the Bank’s current target, or the “core” CPI which it also watches to guide its month-to-month actions).  It is clear that the Bank itself strongly wants to maintain the overall edifice of the present inflation targeting system, and continues to argue that controlling inflation at a low and stable level is the best thing it can do to promote Canadian prosperity.

Inflation targeting was the dominant monetary policy doctrine through the years of the “Great Moderation”: the 1990s and early 2000s, when it seemed as if the fundamental problem of macroeconomic policy had been solved, almost like the “end of history” in Fukuyama’s infamous jargon.  (I discuss the origins of inflation targeting, its essential intellectual continuity with monetarism, and its problems in Chapter 18 of my book Economics for Everyone.)  But the self-righteous superiority of the doctrine came crashing down with the GFC, and even more fundamentally in the years since.  Output gaps are large and persistent.  Deflation, not inflation, is the bigger danger.  Yet inflation does not respond to its assumed causes (the output gap and interest rates).  It’s almost as if inflation targeting has been so effective at “anchoring” expectations, that nothing (even sustained high unemployment) knocks it off those moorings.  Many central bankers are actively exploring alternative policy tools — quantitative easing, negative rates, and even “helicopter money” — to try to stimulate badly-needed growth.  But the Bank of Canada has been relatively conservative, sticking to its traditional playbook.  On the other hand, it is also clear that the Bank’s actions (and in particular, its last rate cuts) cannot be explained according to a narrow reading of its inflation-targeting mandate.  Since the days of Mark Carney it has claimed to be following that mandate in a “flexible” manner, but it is increasingly apparent that the integrity of the whole inflation-targeting model is crumbling.

Some economists (such as Pierre Fortin in his presentation at the 2016 CEA meetings) have called for raising the inflation target, and others have offered more fundamental critiques.  Posted below is my recent Globe and Mail column on the topic.  I wish that progressive economists in Canada had been more on the ball, and prepared to challenge the Bank’s mandate more forcefully in the run-up to the current renewal negotiations.  But there is still time to raise some big, timely questions about the still-dominant belief that the central bank’s one and only mission should be to control the price level.

New Thinking Needed on Monetary Policy (originally published in the Globe and Mail, August 8 2016)

The federal Liberal government has successfully engineered a major about-face in public attitudes toward fiscal policy.  Rejecting the previous preoccupation with balanced budgets, the Trudeau government convinced most Canadians that deficits can make sense – whenever economic conditions require more spending power, not less.

The government now has a similar opportunity to rework conventional wisdom in the other major area of macroeconomic management: monetary policy.  The Bank of Canada’s five-year inflation target mandate expires at the end of this year, and the Bank is currently discussing its future marching orders with Finance Minister Bill Morneau.  A joint announcement on the Bank’s next mandate will be made in coming months.

Since 1993 the Bank has pursued an inflation target of 2 percent (measured by consumer prices), with an allowable cushion of 1 percent either way.  By the specific criteria of meeting that goal, the Bank has a generally good track record: inflation has stayed within its target band three-quarters of the time.  However, a creeping anti-inflation bias is apparent: since 1993, inflation has been twice as likely to fall below the band than above it.  And this one-sidedness has become more apparent since the Bank’s mandate was last renewed in 2011.  Since then the band was missed entirely in 11 months (always from below), and inflation averaged just 1.39 percent, well below the target.
In a world in which deflation is now a bigger risk than inflation, this persistent weakness in consumer prices (which reflects chronic weakness in overall demand and spending power) is worrisome.  And the bigger problem has been the absence of visible economic payoff from the inflation targeting regime.  The Bank doesn’t target inflation for its own sake; it does so because low and stable inflation is supposedly the “best contribution monetary policy can make” to economic progress.  They argue targeting facilitates greater certainty, more investment, and higher productivity.

In fact, however, the exact opposite has entailed.  GDP growth per capita has slowed considerably during 25 years of inflation targeting: averaging 1.4 percent per year, a third less than in the quarter-century before targeting.  Under the Bank’s current mandate, it’s been worse: 0.6 percent and falling.  Business investment has never been weaker.  It seems that stability in inflation means little to companies who worry about whether they can sell their products.

Most worrisome for targeting advocates is the absence of a predictable relationship between inflation broader economic conditions (measured by unemployment or GDP growth).  Targeting has certainly “anchored” inflation expectations around 2 percent.  In fact, even when the economy is clearly underperforming, inflation tends to stick there. By a strict reading of targeting rules (whereby the Bank focuses on inflation, and only inflation), that would eliminate the Bank’s ability to counter economic downswings.  Luckily, the Bank of Canada (since Mark Carney) has been interpreting its mandate more flexibly – cutting interest rates even when inflation alone wouldn’t seem to justify it.  But it is increasingly obvious that inflation targeting has become a polite fiction: it isn’t working the way it is supposed to, and central bank actions are actually motivated by other goals.  Yet the major players remain so invested in the supposed “credibility” of the whole system, that none will acknowledge the emperor’s lack of garb.

The Bank is considering certain minor tweaks to its system, including a possible alternative measure of consumer prices.  But it strongly favours a renewal of the basic target.  Mr. Morneau should demand a bigger rethink.  There are several options for change.

The target could be increased, with inflation allowed to rise to 4 or 5 percent.  Many international and Canadian economists (including Pierre Fortin, former President of the Canadian Economics Association) have advocated this change.  It would help avoid the problems that occur when interest rates are cut to zero; modestly higher inflation is also good for lubricating economic adjustment and eroding the burden of debts.

Alternatively the Bank could be given explicit instructions to pursue other goals (namely, reducing unemployment and spurring growth) in addition to controlling inflation.  After all, the Bank of Canada Act still discusses the Bank’s responsibility to .  More radically, inflation targeting could be abandoned altogether.  That’s not likely, but the option should be considered.

Until recently, inflation targeting was trumpeted as a Holy Grail that solved all the major problems in macroeconomics.  The chaotic state of the global economy confirms this promise was hollow.  We only get to consider the options every five years; this is the time for the government to put everything on the table.