Canada’s Monetary Policy Regime after 2011 EDITED BY DAVID LAIDLER C.D. Howe Institute The C.D. Howe Institute is a national, nonpartisan, nonprofit organization that aims to improve Canadians’ standard of living by fostering sound economic and social policy. The Institute promotes the application of independent research and analysis to major economic and social issues affecting the quality of life of Canadians throughout the country. It takes a global perspective by considering the impact of international factors on Canada and bringing insights from other jurisdictions to the discussion of Canadian policy. Recommendations in the Institute’s publications are founded on quality research conducted by leading experts and subject to rigorous peer review. The Institute communicates clearly the analysis and recommendations arising from its work to the general public, the media, academia, experts, and policymakers. 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Cover design by Heather Vilistus Photography by Iain Fleming Printed in Canada by Ricoh 205 Industrial Parkway North, Aurora ON L4G 4C4 May 2010 TABLE OF CONTENTS PREFACE . v PART I INTRODUCTION by David Laidler . 3 PART II HISTORY AND POLITICS CHAPTER 1 Canada’s Difficult Experience in Reducing Inflation: Cautionary Lessons by John Crow . 17 CHAPTER 2 To the Next Level: From Gold Standard to Inflation Targets – to Price Stability? by William Robson . 31 PART III INTERNATIONAL EXPERIENCE CHAPTER 3 As Good As It Gets? The International Dimension to Canada’s Monetary Policy Strategy Choices by Pierre Siklos . 59 PART IV ANALYTIC ASPECTS OF TARGETING CHAPTER 4 What is the Ideal Monetary Policy Regime? Improving the Bank of Canada’s Inflation-Targeting Program by Michael Parkin . 93 CHAPTER 5 How Flexible Can Inflation Targeting Be? Suggestions for the Future of Canada’s Targeting Regime by Thorsten Koeppl . 115 PART V MATTERS OF MEASUREMENT CHAPTER 6 The Missing Links: Better Measures of Inflation and Inflation Expectations in Canada by Gregor Smith . 135 CHAPTER 7 Getting it Right When You Might Be Wrong: The Choice Between Price-Level and Inflation Targeting by Jean Boivin . 155 PART VI TARGETING AND FINANCIAL STABILITY CHAPTER 8 Unstable Foundations: Asset Markets, Inflation Targets, and Canada’s 2011 Policy Choices by David Laidler and Robin Banerjee . 171 PREFACE Money is one of humanity's most powerful tools. Its Commentaries, Backgrounders and e-briefs on a myriad of public-good characteristics make it a subject of extensive monetary questions: debates over goals, instruments and government intervention in the modern world. Yet indicators; whether to peg, manage or ignore the foreign governments' management of money and the financial exchange rate; and how and when the Bank of Canada infrastructure that goes with it is opaque to most people, should announce its targets for money-market interest rates. and the mechanics and macroeconomic effects of monetary Since 2005, the Institute has also sponsored a Monetary policy are controversial even among experts. The political Policy Council, comprised of 12 of Canada's leading environment in which central bankers operate, their goals academic and financial-market economists, that offers and tactics, and the interplay between credit and money, recommendations about the monetary stance appropriate interest and foreign-exchange rates, and spending, output to hitting the inflation target in advance of each of the and inflation, are all therefore important subjects for Bank of Canada's policy rate announcements. scrutiny by independent researchers, including think-tanks. Looking to the future, the need has never been greater This latest in a decades-long series of volumes on for an expanded and sustained research program in Canadian monetary policy from the C.D. Howe Institute monetary and macro-financial policy. This and the C.D. appears at a pivotal moment, both for the subject, and for Howe Institute's salient contributions in the field, have the Institute`s work on it. inspired six of Canada's major banks and three of its major Taking the subject first, monetary policy in Canada has insurance companies to support a new Monetary Policy come a long way since the collapse of the Bretton-Woods Endowment at the Institute. This book, which brings system based on a gold-convertible US dollar in the early together eight of the C.D. Howe Institute's most recent 1970s. That event unbottled the genie of pure fiat currencies contributions to monetary policy discussions with an issued by government-controlled central banks, which led introduction by its editor, David Laidler, is a valuable to almost two decades of erratic and often high inflation in compilation of top-quality thinking about redefining the Canada and elsewhere. This experience prompted a move Bank of Canada's goals. Its publication to accompany the by many major developed countries to inflation targeting. launch of the Monetary Policy Endowment is a tribute to Canada was in the forefront of this movement, adopting the public-spiritedness of BMO Financial Group, CIBC, targets in 1991, and from the end of 1995 through 2007, RBC Financial Group, Scotiabank, TD Bank Financial the Bank of Canada targeted 2 percent annual increases in Group, Great-West Life, Manulife Financial, National the consumer price index with considerable success. Yet just Bank, and Sun Life Financial for their commitment to as researchers were turning their attention to building on this vital area of Canadian economic policy. these gains, potentially by moving to price-level targets when I thank James Fleming, the Institute's Editor, and the current inflation-targeting period ends in 2011, the Heather Vilistus, its Page Layout Designer, for their work 2008 financial crisis and 2009 global recession subjected the in producing this volume. I gratefully acknowledge the monetary regime to stresses as great as any since World War authors of the individual chapters in the volume, along with II. Monetary policy is thus at a point of flux: debate over the many reviewers and discussants of the previous drafts, goals coincides with re-examination of many tactics and for their insights and their energy. And I take special delight mechanics of monetary control. in paying tribute to the volume's editor, David Laidler, a As for the C.D. Howe Institute, its research program has long-time friend and collaborator, and an essential driver of featured monetary policy prominently for decades. A series the C.D. Howe Institute's monetary policy work for two of major studies - two by Thomas J. Courchene, one by decades. As with all Institute publications, the views Peter Howitt, and two by David Laidler and me working expressed in this volume are those of the authors and do together - have documented the evolution of Canadian not necessarily reflect the views of the Institute’s donors, monetary policy since the mid-1970s. Three substantial members or Directors. volumes edited by Richard Lipsey, Robert York and David Laidler in the 1990s explored the strategy and tactics of William B.P. Robson inflation control and inflation targeting. And over the past President and CEO decade, the Institute has published more than 30 shorter (v) PART I Introduction INTRODUCTION By David Laidler Inflation Targeting in Canada they do not present a uniform position from which a well-defined post-2011 policy program immediately Formal inflation targeting began in Canada in 1991, follows, they nevertheless narrow down the options and since 1995 monetary policy has aimed, year in considerably and clarify some substantive issues that and year out, at an inflation rate for the Consumer still need more discussion before the current regime is Price Index (CPI) of 2 percent per annum, plus or either extended or replaced. Specifically, though minus one percentage point.1 This regime has surely prolonging the status quo is quite clearly still an helped to create a more stable macro-economic option, these essays’ predominant theme is that the environment than prevailed in the 1970s and ‘80s, time has probably come to aim monetary policy at but there is nevertheless something unsatisfying about something closer to that above-mentioned “price it. To the lay observer, its relationship to the grand stability” goal.