Bank of Canada’s targeting has evolved a commodity By Paul Beaudry and Amartya Lahiri February 1, 2016 – The Globe and Mail

Canadians recently reopened the debate about commodity prices? Second, should the Bank of the previously taboo subject of fiscal deficits. Is Canada do anything about it? it also time to reopen the debate about the Bank Canada produces and exports many products, of Canada’s narrow focus on inflation and its commodities being simply an important general hands-off approach to exchange-rate component. Commodity prices are typically movements? determined in international markets, Over the past year, the value of the Canadian denominated in U.S. dollars and tend to be very dollar has depreciated precipitously. How does volatile. Given a choice, how should we want the Bank of Canada react to such a change? the Canadian economy to adjust to these price Given that it is an inflation-targeting central movements? There are two extreme bank, its response is to generally disregard such possibilities. exchange-rate movements and instead focus on On the one hand, we could want stable prices setting policy in a manner that is most likely to of commodities in Canadian dollars, which help inflation attain its target of 2 per cent. Is would have the benefit of stabilizing the oil and this the best policy for Canada? We believe not. commodity sectors. This requires the Canadian Inflation targeting was implemented by the dollar to fluctuate substantially with Bank of Canada in the early 1990s, after a international commodity prices, which means period of substantial variation in the rate of that the prices of other imports and exports in inflation. It has been highly successful at Canadian dollars must fluctuate strongly. stabilizing the inflation rate and, for this reason, Alternatively, we could want the demand for it should be applauded. However, one key our other exports – such as manufactured goods implication of adopting inflation targeting is – to be more stable. This would require the that the bank does not directly target the dollar to be relatively stable against our trading . Instead, it lets it be determined partners. by market forces. Which of these choices would be better for the By taking this hands-off approach, the bank has Canadian economy? That depends on which left the market considerable leeway on deciding sector is better able to adjust to large price how to determine the exchange rate, at least in fluctuations. The commodity sector appears the short run. Over time, the market has better suited to handle large price fluctuations, coalesced around the notion that the dollar the main reason being that, after a period of should fluctuate closely with commodity shutdowns, it is relatively easy to restart prices. This wasn’t always the case. Before the production anew when the price is high again. inflation targeting period, commodity prices In contrast, our other export sectors may not had very little predictive power for the have such flexibility. When the dollar rises with Canadian dollar. In this sense, the inflation- the price of commodities, manufacturing targeting regime has allowed and supported its exports tend to lose competitiveness and firms evolution into a commodity currency. close up shop. This trend raises two related questions. First, One might think that when the dollar falls back, does the dollar now fluctuate excessively with this should induce non-commodity firms that had left Canada to start up again. However, The desirability of exchange-rate targeting is a starting up again in most of these sectors is very highly debated issue. Research on the topic has difficult, much more so than starting up oil mostly found that strict exchange-rate targeting production. This is one of the reasons is hazardous and often fails. However, the fluctuations in the Canadian dollar are current inflation targeting framework that becoming greater. Producers of non- governs monetary policy in Canada, with its commodities recognize that the dollar has hands-off view regarding the exchange rate, become a commodity currency and accordingly may not be the best option. The emergence of require a weaker and weaker dollar to return to the Canadian dollar as a commodity currency produce in Canada as they know that such a was not one of the objectives of the inflation- situation is likely to be temporary, lasting only targeting regime, but it has become one of its until the next commodity boom. In short, there unintended consequences. For this reason, it is a strong case to be made that the Canadian would be a good time for the Bank of Canada economy would be better off in the medium and to reconsider its inflation-targeting framework. long run if the commodity sector absorbed Paul Beaudry is a professor at the University of British more of the fluctuation in commodity prices, Columbia’s Vancouver School of Economics, a Fellow of thereby allowing demand in non-commodity the Royal Society of Canada and a former fellow of the sectors to be more stable. Bank of Canada. Amartya Lahiri is a professor at the Vancouver School of Economics.