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Canada's Approach to Price Stability

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Canada's Approach to Price Stability TOWARD 2021: REVIEWING THE MONETARY POLICY FRAMEWORK Remarks by Lawrence Schembri Deputy Governor of the Bank of Canada Manitoba Association for Business Economists Winnipeg, Manitoba February 15, 2018 Anchoring Expectations: Canada’s Approach to Price Stability Introduction Thank you for the invitation to speak to you today here in the hometown of James Coyne. Mr. Coyne, who died in 2012, was the governor of the Bank of Canada from 1955 to 1961. As governor, he stressed that price stability should be the primary function of monetary policy. That principle—price stability—is now the cornerstone of monetary policy frameworks around the world. In practice, it is achieved by maintaining inflation at a low, stable and predictable level. Our mandate at the Bank of Canada’s is to “promote the economic and financial welfare of Canada.” And, like former Governor Coyne, we believe that inflation control is the main contribution monetary policy can make to achieving that goal. Our current monetary policy framework consists of an explicit inflation target and a flexible exchange rate. It was established in an agreement with the federal government in 1991 and, since 2001, has been renewed every five years. With this framework, we have anchored inflation expectations, achieved low and stable inflation, and promoted sustained employment and economic growth. Three main factors have contributed to the framework’s credibility and success. First, we have a clear, simple and well-understood inflation target, whose focal point is 2 per cent. Second, the framework has political legitimacy, is coherent with other public policies and is implemented with effective tools. And third, we have a formal review process for continually improving the framework that is I would like to thank Robert Amano and Thomas Carter for their help in preparing this speech. Not for publication before 15 February 2018 13:30 Eastern Time - 2 - widely admired by many of our peers and was cited as one of the factors that earned us the Central Bank of the Year Award we received recently. My speech today is the first in a series that my colleagues and I will be delivering over the next four years as we embark on our review of the framework leading up to the 2021 renewal of the inflation target. I’ll start with some background on our experience—and that of many other central banks—with inflation in the 1970s and 1980s and on the lessons we learned trying to control it. I’ll discuss how and why the Bank adopted an inflation target for its monetary policy. I’ll review the impact of the policy on inflation, why it works so well, and the unique and innovative process we follow to ensure that it remains effective. Finally, I’ll conclude with a discussion of important economic developments affecting economies worldwide. Strengthening the framework to manage the potential risks these developments pose to the Canadian economy is the key objective of our research over the next four years. The search for an anchor Monetary policy needs a nominal anchor or a fixed point of reference to help tie down the expectations people have about inflation. During the 1960s, that anchor in most countries was a pegged nominal exchange rate that linked the value of domestic currencies to the US dollar.1 This exchange rate arrangement, known as the Bretton Woods system, collapsed in the early 1970s, largely because of unsustainable inflationary pressure in the United States. Without an anchor for monetary policy, inflation and inflation expectations rose rapidly, exacerbated by large oil price shocks. In some years, inflation hit double-digit levels in Canada and in other advanced economies. Economist Milton Friedman’s great insight into inflation is that it is always and everywhere a monetary phenomenon, which led him to claim that low inflation could be achieved by controlling the growth rate of money. He also emphasized that inflation expectations are influenced by monetary policy and that they eventually adjust to actual inflation. For this reason, he argued, there is no long- run trade-off between inflation and output.2 Thus, central banks should focus on controlling inflation. In 1975, the Bank adopted a money supply target. But, by 1982, we were forced to abandon it—or, rather, it abandoned us, as former Governor Gerald Bouey once quipped—after it became clear that financial innovations had weakened the Bank’s ability to control the money supply and overall spending with its policy 1 In turn, the US dollar was convertible to gold at a rate of US$35 an ounce. 2 Friedman’s analysis of inflation expectations and a vertical long-run Phillips curve can be found in M. Friedman, “The Role of Monetary Policy,” Presidential Address delivered at the American Economic Association, 1967, and published in The American Economic Review 58, no. 1 (March 1968): 1–17. - 3 - interest rate.3 Unfortunately, by then inflation and inflation expectations had risen and the expectations had become so entrenched that inflation declined only when the Bank of Canada and most other major central banks boldly increased interest rates in the early 1980s. It worked, but at the cost of a severe global recession. After this disinflation, the Bank renewed its search for a viable nominal anchor and considered various options.4 We tried to identify one that would be effective, straightforward to operationalize and easy to communicate, and that the public would trust. In the late 1980s, then-Governor John Crow delivered several speeches in which he laid out an argument in favour of price stability itself as a long-run goal for monetary policy.5 The inflation rate was then running at roughly 5 per cent. No one knew with certainty what rate best represented price stability. And economic theory was not yet developed enough to confidently predict the outcome of such a policy, if implemented. Still, the idea of using the policy rate to directly target the rate of inflation held promise. At the time, only one other country in the world had attempted such a policy approach: New Zealand adopted inflation targeting in 1990. Canada became the second the following year when the Bank and the Department of Finance announced an agreement on a monetary policy framework that set a path for reducing inflation.6 The agreement gave the Bank operational independence to use its statutory tools to achieve the inflation target, while at the same time acknowledging that “a range of public policies, besides monetary policy, can make a significant contribution” to controlling inflation.7 3 The measure of the money supply targeted was M1, which includes its most liquid components: coins, cash and chequing accounts. The innovations that made it difficult to target were in both non-personal and personal banking. The years leading up to and following its abandonment in 1982 witnessed an exhaustive search for alternative, broader aggregates of the money supply that could be targeted instead, although a suitable replacement was not ultimately found. For an account of this search, see F. Caramazza, D. Hostland and S. Poloz, “The Demand for Money and the Monetary Policy Process in Canada,” Journal of Policy Modeling 12, no. 2 (Summer 1990): 387–426. 4 These options included different monetary aggregates, along with nominal spending, the exchange rate and the price level. See P. Duguay and D. Longworth, “Macroeconomic Models and Policy Making at the Bank of Canada,” Economic Modelling 15, no. 3 (July 1, 1998): 357–75. 5 J. Crow, “The Work of Canadian Monetary Policy,” The Eric John Hanson Memorial Lecture Series II (Winter 1988), Department of Economics, University of Alberta, Edmonton, January 18, 1988. 6 The agreement established a path for a progressive reduction in the rate of inflation to 3 per cent by the end of 1992, 2 1/2 per cent by the middle of 1994 and 2 per cent by the end of 1995. The agreement provided no specific target for the post-1995 period, although it was understood that the experience of the first four years would inform the selection of the target. The target has remained at 2 per cent since then and is tracked by Statistics Canada’s measure of total CPI inflation. 7 The Bank of Canada Act gives the Minister of Finance the ability to issue a binding directive to the Governor if the two encounter irreconcilable differences concerning monetary policy. This power has never been exercised. Its use would entail significant political costs: the directive must be made public and would likely trigger the Governor’s resignation. - 4 - Since 1995, our inflation-control target has been 2 per cent, the midpoint of a 1 to 3 per cent range. Central banks in many other countries—37 in total—have now also adopted an inflation target and most, especially in advanced economies, have chosen 2 per cent as their target. Experience suggests that 2 per cent is sufficiently low that it does not materially distort economic decision making and behaviour, but still leaves the central bank adequate room to lower its policy rate in response to a significant adverse shock to the economy. Because a 2 per cent target balances these offsetting considerations, it is symmetric. In other words, we care equally about deviations above and below 2 per cent. The 1 to 3 per cent range reflects normal variations in consumer price index (CPI) inflation, since it is subject to a wide variety of temporary shocks. These ongoing shocks make it impossible to hit the 2 per cent target consistently. We aim to achieve the target by adjusting our policy rate, which directly influences interest rates for household and corporate borrowing.
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