Central banks in Europe, the U.S. and Canada are fretting over inflation that is below target, stoking fears of deflation, and debate rages over the best way to handle the problem. And, as a couple of decades of Japanese economic history show, deflation can be a big, big problem. The real value of nominal liabilities appreciates, and households struggle to meet fixed-interest rate payments on those liabilities. One approach to dealing with inflation or deflation, known as price-level targeting, is intriguing because it responds directly to the problem. Intriguing, too, because it shares features with the “forward guidance” policy currently in vogue in the U.S. and the U.K. Price-level targeting involves targeting a path for the price level instead of an inflation rate. Under price-level targeting, for example, the Bank of Canada would pursue inflation above target, for a time, to compensate for inflation that was below target in the past.
The idea is also intriguing because between 2006 and 2011, the Bank of Canada pursued an active research program that investigated the possibility of a major revision to its monetary policy framework, and one of the options it seriously considered was price-level targeting.
In the 2011 background document to the renewal of its inflation-control target with the government, the Bank stated that the potential benefits did not clearly outweigh its assessment of the risks associated with such a switch. “This assessment could change in the future, however,” if further research showed price-level targeting to be potentially more useful or allayed some of the Bank’s misgivings. Nonetheless, the Bank’s research program seems to have been quietly shelved. There has been little further discussion at the Bank or in policy circles about its merits.
This raises two important questions. First, where might the Canadian economy be if price-level targeting had been adopted in 2011 – when alternative targets for monetary policy were last reviewed? Second, what were the main unstated reasons why the Bank of Canada chose not to pursue inflation targeting in 2011?
There are reasons to think the Canadian economy would be better off. There are also reasons to think that a major unstated reason for the Bank’s decision not to try price-level targeting is that such a regime constrains it to announce and stick to its future policy. The Bank evidently prefers a regime in which bygones are bygones, allowing it to decide on its policy based solely on current economic conditions.
If price-level targeting were implemented, and well understood by market participants, the expected real interest rate would be lower in the short to medium run, providing a boost to demand. This would be welcome in a context where employment has showed anemic growth and with output expected to remain below potential well into 2015.
A price-level target would also leave the Canadian economy better prepared to weather future crises. Two of the main results of the Bank’s own research program lead to this conclusion. First, major financial shocks are exactly what can drive the Bank’s policy rate to its effective lower bound, where it remained between April 2009 and May 2010. Second, price-level targeting can reduce the need for the Bank to lower short term rates in response to such shocks, helping it avoid the “zero lower bound” at which its main policy tool becomes ineffective.
The qualification that the price-level targeting framework be well understood is important: Inflation expectations would have to become flexible and dependent on the past “misses” with respect to the price-level target. This is the Bank’s major stated reason for not trying price-level targeting.
The unstated reason is that the Bank values its discretion. The Bank did engage in forward guidance during the financial crisis in 2009, but it was conditional on economic conditions: The exact conditions which would lead it to renege on its announced path for the target rate were left vague. Then-governor Mark Carney’s 2012 speech, “A Monetary Framework for All Seasons” stated clearly that the Bank’s inflation-targeting was flexible, allowing it to “deliver the expected while dealing with the unexpected.”
Usually, central bankers, including Governor Carney, interpret commitment to mean rigid obedience to rules, which might hamper their abilities to react to the unexpected, rather than announcing and sticking to current policy. These announced policies could of course be made dependent on future unexpected events, but then the Bank would have to respond to unexpected events in a more predictable way.
Clearly, a repeat of the 2008 financial crisis is possible. The benefits of price-level targeting in the face of such a possibility are too important to ignore. The Bank should revive its research program and give more serious consideration to becoming a pioneer of price-level targeting, just as it was a pioneer of inflation targeting.
Steve Ambler is David Dodge Chair in monetary policy, C.D. Howe Institute, and professor, Département des sciences économiques, Université du Québec à Montréal.