I first heard the gibe that “central bankers think inflation is always and everywhere a monetary phenomenon – except this time, of course” more than 50 years ago, but it is still as good as new.
Consider the Bank of Canada, now caught in a trap of its own making. Its mandate, pending an imminent renewal, requires it to maintain inflation in a range around two per cent, but its “forward guidance,” issued incessantly for the past year, has promised to keep the overnight rate of interest at 0.25 per cent until the real economy has returned to “normal” — at a date that lately seems to have been creeping closer from its original value somewhere around the end of 2022. The Bank is stuck with two quantitative targets, one, an inflation target agreed with the government that is its ultimate policy goal, and the other, its own creation, its target for the overnight rate, which is its main policy instrument. And it doesn’t seem to have thought much about what to do if they proved incompatible, which they now have. So: how did the Bank get into this mess, and more important, how does it extract itself?
We shouldn’t criticise the authorities for rapid resort to strong and unconventional stimulus when COVID-19 struck last March. To continue with “inflation targeting as usual” in those circumstances would have been a bit like sticking to the rules of the Gold Standard in the summer of 1914. Nor should we really complain that the stimulus turned out to be a bit excessive — better too much than too little under the circumstances, surely? The Bank’s fault, which it has shared to varying degrees with the Fed, the European Central Bank and the Bank of England, lay in failing to appreciate sufficiently the inflationary risk inherent in its measures, and even more so, in issuing its forward interest-rate guidance with an unwarranted degree of certainty.
At the beginning of 2020, Canada’s broad money supply, “M2++”, was growing at an annual rate about eight per cent measured over the previous three months, as it had, more or less, for the previous decade. (M2++ includes cash, chequing and savings accounts and other types of highly liquid assets that could be turned into cash quickly.) By the end of June it was growing at over 20 per cent, and though this rate fell back to a little over 10 per cent by the beginning of 2021, it has shown little sign of slowing down further until very recently.
Bursts of broad money growth don’t always lead on to inflation. But often they do. So whenever they occur, and especially if they show signs of lingering, policy-makers need to investigate the reasons why — promptly and carefully. To judge by the public record of its forward guidance, the Bank of Canada totally ignored money’s warnings this time around and failed even to entertain the thought that it might be overdoing expansion a bit and that an upsurge in inflation might be on the cards for 2021. It wasn’t alone, of course. The Fed in particular made the same mistake, if anything on a larger scale, thus ensuring that the inflation we face is now well embedded in international as well as Canadian markets.
With an unnecessary fall election out of the way, the Bank is now freer to take action than it was earlier this year, and if the current winding down of “Quantitative Easing” were to be accompanied by a first overnight rate increase early in the new year, that would be welcome. But this is not a plea for any major speed-up of monetary tightening thereafter. The damage on the inflationary front is now done and needs to be undone gradually. The national political mood is too fragile to risk a sudden downturn, and the Bank needs to take care about not losing any more public support.
Above all, it needs to begin rebuilding its credibility. To this end, its current inflation control mandate must be renewed with firm political backing, and without the addition of further bells and whistles. The Bank has already had more than enough trouble meeting a simple goal under very trying circumstances, and to give it a more complicated mandate would only expose its reputation to the risk of further damage. And then it needs to set a clear date for getting inflation back to its target range — two or three years hence perhaps — with no accompanying guidance about what this might imply for the time path of interest rates. There is no way of forecasting this time path under current circumstances, and the Bank should say so explicitly, as it swears off the kind of forward guidance that has already caused it so much trouble.
David Laidler is Professor Emeritus of Economics at Western University and a Research Fellow at the C.D. Howe Institute.