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Reflections on Bank of Canada Monetary Policy Over the Past Thirty Years

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Reflections on Bank of Canada Monetary Policy Over the Past Thirty Years DRAFT: NOT FOR CITATION REFLECTIONS ON BANK OF CANADA MONETARY POLICY OVER THE PAST THIRTY YEARS By Charles Freedman, Scholar in Residence, Economics Department, Carleton University, Ottawa, Canada* (presentation at a “Conference on ‘New’ Monetary Policy: Implications and Relevance” at Downing College, University of Cambridge, Cambridge England, March 19, 2004 and at a Robinson workshop, University of Ottawa, April 2, 2004) “Central bankers are always looking for more reliable guides to the conduct of monetary policy than they have had.” Bouey ( Monetary Policy--Finding a Place to Stand, Per Jacobsson lecture, 1982) A. INTRODUCTION This paper discusses the developments underlying the changes in the monetary policy framework in Canada over the past 30 years. Since the mid-1970s, monetary policy in Canada can be characterized as using, or searching for, a nominal anchor in a flexible exchange rate environment. Basing policy on a nominal anchor was viewed as a way of avoiding systematic policy errors of the sort that led to the breakout of inflation in the late 1960s and the first half of the 1970s. 2 There are four main nominal anchors discussed in the literature -- a fixed exchange rate, a monetary aggregate target, a nominal spending target, and a price inflation or price level target. Of these, only two, a monetary aggregate target and an inflation target, were used in Canada in the period under discussion. Canada operated under a floating exchange rate regime over the entire period. And, to my knowledge, no country has used nominal spending as an official target. In the 1975-82 period, the anchor in Canada was the narrow monetary aggregate M1. With the withdrawal of M1 as a target in 1982, the Bank of Canada searched for an alternative anchor for the rest the decade. In 1991, it introduced inflation targeting, which has subsequently served as the basis of policy. B. THE SITUATION IN THE MID-1970S To set the scene for a detailed discussion of the monetary policy arrangements over the past 30 years, I want to begin with a brief summary of the situation in Canada and much of the industrialized world in the mid-1970s. Inflation had become a major problem for economic policy, following an increase in the latter part of the 1960s and a sharp rise in the 1972-75 period. Expectations of future inflation were becoming increasingly entrenched, with a widespread view that rates of inflation were likely to remain high. 3 While many economists explained these developments by the time inconsistency model, my own view is that the step up of inflation in the latter part of the 1960s and its acceleration in the 1970s was the result of the interaction of economic shocks and policy errors. The shocks included the increase in aggregate demand related to the Vietnam war in the latter part of the 1960s, the sharp oil price increase in 1973, and shifts in the natural rate of unemployment and/or the capacity rate of growth of output in the first half of the 1970s. The policy errors that led to the accommodation of the shock-induced inflation pressures resulted from an incorrect framework of analysis and insufficient regard for the costs of inflation. Together, these factors resulted in what might otherwise have been a transitory bout of inflation pressures turning into an ongoing period of high and pervasive inflation. Recall that the prevailing view among economists (if not among all central bankers) in the 1950s and 1960s was that there was a long-run trade-off between output (or unemployment) and inflation, and that the role of the authorities in this framework was to choose the optimal point on the trade-off curve. The appearance of a trade-off was a reflection of an environment in which inflation expectations were low and stable, and there was a lack of attention to the potential role of inflation expectations in the inflation process. The firmly held expectations of continuing low inflation at 4 the time were likely the result of a long period of low peace-time inflation outcomes, buttressed by the fairly conservative economic policies of the 1950s. Moreover, at the time, the economics profession underestimated the costs of inflation, since economists had difficulty in quantifying those costs. The empirical relationship between high rates of inflation and unpredictable rates of inflation was not widely recognized. Nor was there much awareness at the time of many of the links between even a predictable or expected rate of inflation and unfavourable economic outcomes. The Vietnam war expenditures and the political decision to have both “guns and butter” was the direct cause of a period of excess demand in the second half of the 1960s, while the synchronized expansion of the major world economies was the key factor in creating global excess demand in the early 1970s. And the supply shocks in the 1970s, including the oil price shock, were both facilitated by the environment of global excess demand and exacerbated the inflationary pressures. Although policymakers responded to the situation of strong demand and supply shocks by taking tightening actions, these actions proved to be far from sufficient to offset the upward pressures on inflation, especially in the 1970s. In part, the overly weak response to the demand and inflation pressures reflected a less-than-complete realization of the implications of unhinging the low level of 5 inflation expectations that had provided an anchor for low inflation in preceding years. As well, in the early 1970s there was a worldwide decline in the rate of growth of productivity and, in some countries, a rise in the natural rate of unemployment. In Canada, both of these shocks occurred, with the rise in the natural rate of unemployment linked in part to an increase in the generosity of the unemployment insurance arrangements. Only gradually did the authorities become aware of these important structural changes in potential output growth and the natural rate. Thus, policymakers were focussing on indicators of labour market and product market pressures that were very misleading. On the basis of these indicators they believed that they were tightening policy sufficiently to offset the inflationary pressures. It was also likely the case that insufficient attention was paid to the distinction between nominal and real interest rates. In the event, with the decline in the rate of growth of capacity, demand remained at unduly high levels relative to capacity, and the actions that policymakers took were insufficient to offset the inflation pressures. The experience of high inflation, and the increased understanding by economists and central banks of the inflationary process and the costs of inflation, led to a stronger commitment to move the rate of inflation down and to keep it at low levels. However, the persistently high inflation rates of the 1970s had unhinged inflation expectations, thereby rendering the process of returning inflation to a lower path more difficult. Once the genie of inflation was out of the bottle it proved very difficult to get it back 6 in. Indeed, the rate of inflation only returned to low levels following a major worldwide recession in the early 1980s and another, in some countries, in the early 1990s. [To sum up, the combination of an overly-optimistic estimate of capacity, an underestimate of the costs of inflation and insufficient attention to inflation expectations meant that policymakers were not aware at the time that they were taking serious risks of overheating the economy and they did not act sufficiently vigorously to offset the inflationary pressures that developed. And once inflation expectations became entrenched at a high level, it became much more difficult to get the rate of inflation down than would have been the case in an environment in which the public expected that inflation shocks would be temporary and rapidly reversed.] C. MONETARY AGGREGATES AS TARGETS IN CANADA, 1975-1982 Against this background, many industrialized countries started to target monetary aggregates in the mid-1970s, with the objective of bringing down the rate of inflation from the high level that it had reached to the much lower level that was believed to be necessary for good economic performance. Thus, the policy goal was to gradually bring down the targeted rate of growth of some measure of money (narrow in some countries, broad in others) from a high starting point to a much lower level and 7 thereby wring inflation out of the system, and then to maintain a low rate of growth of money. In Canada, the Bank of Canada introduced monetary aggregate targeting in late 1975, aiming at achieving a decelerating rate of growth of the narrow aggregate M1 in order to bring down the rate of inflation from the double-digit levels that it had reached. While a great deal of academic research had been done on the relationship between the growth of monetary aggregates and the rate of inflation, a lot of internal analysis had to be done in the Bank on the demand for money relationship in Canada and on some of the mechanics of using a monetary aggregate as the target. Economists held different views of the mechanism at work that would link the deceleration of money growth to a decline in the rate of inflation. The more monetarist view focussed on a direct causal link between money growth and the rate of inflation. The typical view in central banking circles, in contrast, was that the mechanism operated through more traditional, structural relationships. Thus, too high a rate of inflation (i.e., one that was higher than consistent with the targeted growth rate of money) would result in a rise in the rate of growth of money demanded above the target rate, leading the central bank to raise policy interest rates.
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