Another step in the end of inflation targeting?

Watch the coming renewal of the Bank of Canada’s mandate closely for signs it may relax its fight against inflation.

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(Photo: Adrian Wyld/CP)

Canada may be a step closer to tolerating higher inflation. A House of Commons committee has been asked to review what objectives the Bank of Canada’s monetary policy should pursue. Since 1991 the BoC has pursued “inflation targeting,” meaning that in theory its slavish objective has been to maintain inflation at about 2% a year over the medium-term. It achieves that by raising or lowering its policy interest rate, which influences other interest rates such as what you’ll pay on your mortgage or auto loan, and the return you’ll get on the balance in your savings account. In essence, the Bank’s raison d’etre has been to keep prices growing at a stable rate. A change in this status quo could have a significant impact on your financial well-being.

Inflation targeting has dominated the thinking of many western central banks for most of the last two decades. One reason for its popularity is perhaps that inflation has been relatively easy and painless to fight over that period. Another is that the public deeply resents inflation. However, a month ago I pointed out some reasons to wonder whether inflation targeting might be going out of style. Since the financial crisis it has become increasingly challenging for central banks to maintain price stability without compromising other political objectives, such as encouraging economic growth. Most governments of developed countries have spent the last several years attempting at all costs to keep their economies out of recession, and in doing so appear to have taken their eye of inflation. There’s a growing sense that inflation targeting is no longer adequate to tackle contemporary economic challenges. A few central banks, notably the Bank of England, appear to have quietly abandoned the philosophy altogether.

Now Canada appears to be quietly backing away, too. By the end of this year the federal government must renew the BoC’s mandate, which it does every five years. The mandate is basically BoC governor Mark Carney’s marching orders, and inflation targeting has been enshrined in them the last five times the mandate has been renewed (in 1993, 1998, 2001 and 2006). The Globe and Mail recently speculated that the mandate will remain largely the same, but that it may be amended “to include a forceful assertion of what he [Carney] calls ‘flexible inflation targeting,’” or his right to respond to economic shocks or dangerous buildups of credit by taking longer than usual to bring inflation to the central bank’s 2% target.”

This is something to watch closely. “Taking longer than usual” could amount to taking no action at all.

That already seems to be happening in Britain, as I pointed out in my previous post. The U.K.’s Office for National Statistics reports that inflation there is running at an annualized 5.2%, well above the Bank of England’s 2% target. Invoking the logic of inflation targeting, theoretically this situation seems to demand that the BoE raise its bank rate (currently at a rock-bottom 0.5%) to bring inflation back down to the target range. But BoE governor Mervyn King has shrugged that off by suggesting the problem will resolve itself. “Inflation is likely to rise to above 5% in the next month or so, boosted by already announced increases in utility prices,” he wrote in a letter to George Osborne, the Chancellor of the Exchequer, earlier this month. “But measures of domestically generated inflation remain contained and inflation is likely to fall back sharply next year as the influence of the factors temporarily raising inflation diminishes and downward pressure from unemployment and spare capacity persists. The deterioration in the outlook has made it more likely that inflation will undershoot the 2% target in the medium term.”

King may be right. However, it may also be the case that he and his political masters are more concerned with keeping Britain’s teetering economy out of recession than they are about fighting inflation. Inflation of 5% is very high compared to what’s been experienced in recent history. If it continues, it won’t be long before the British public notices the pound’s dwindling purchasing power.

Carney, in contrast, does not currently face a serious inflation problem. Statistics Canada says the Consumer Price Index (Canada’s primary measure of inflation) is running at an annualized 3.1%, slightly above target but still in the comfort zone. As long as that remains the case, the calls to raise the overnight rate from its current anemic 1% will be subdued. This is perhaps an ideal time for the Bank’s mandate to change—when few are paying attention.

It’s still far too early to claim the Bank of Canada might turn its back on inflation. But what might be the consequences if it did? Well, the last time the Bank of Canada’s mandate was renewed here’s what it had to say about the wonders of inflation targeting:

A low-inflation environment has contributed to sound economic performance and the well-being of Canadians in a number of important ways. Consumers and businesses have been able to manage their finances with greater certainty about the future purchasing power of their savings and income. Nominal interest rates, both short and long term, have been much lower and more stable. Output growth in the economy has been generally higher and significantly more stable, while unemployment has been lower and less variable. The more stable price environment provided by inflation targeting has also helped the economy adjust to economic shocks, such as the global high-tech bubble, 9/11, SARS, and the rapid rise in oil prices, allowing businesses and households to allocate resources more efficiently.

Why should you care? Inflation can be regarded as a way in which governments take the pressure off borrowers (or encourage them) at the expense of savers. Many of us are both, but to varying degrees. If you have an RRSP, pension plan, savings account or piggy bank, presumably you’re hoping that the contents will buy approximately the same goods and services tomorrow as they do today. Yet history has shown that governments are not always willing to do what it takes to make sure your money holds its value. We may be entering such a period yet again.

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