-A A +A

April 20, 2021 - The Bank of Canada should not overhaul its 2 percent inflation-targeting regime when it comes up for renewal later this year, says a new report from the C.D. Howe Institute.

In “Weighing the Options: Why the Bank of Canada Should Renew Inflation Targeting” leading monetary economist Stephen Williamson evaluates the alternatives to the Bank’s current inflation-targeting agreement, and finds that none of the other options are likely to improve upon the current agreement that has served Canada well since 1991.

Williamson argues inflation targeting has been an effective tool for Canada. The Bank of Canada has been successful in keeping inflation close to its 2 percent target since its adoption, with inflation falling within the 1 percent to 3 percent bounds, for the most part. And, the author notes, success in hitting the inflation target has been consistent with good macroeconomic performance.

The author writes that any inflation goal set by a central bank needs to be easily understood by central bankers and the public, so it should be straightforward for them to determine when the central bank is achieving its goal, and when it is not. It should also be feasible for the central bank to achieve this goal. Finally, achieving the goal should imply that economic performance is better than under the best alternative.

“The Bank of Canada’s 2 percent inflation target is tried and true,” said Williamson. “While many alternatives have been proposed, none of them look to be an improvement on what we already have in place. Importantly, the 2 percent target is clear, simple, and makes it obvious to the public when the Bank is not achieving its goals.”

The alternatives to the current inflation-targeting agreement are:

  1. Retaining the inflation targeting approach, but increasing the target above 2 percent – If the Bank of Canada were to increase its inflation target to 3 or 4 percent, for instance, it would increase welfare losses from inflation, while calling the bank’s credibility into question for its perceived willingness to switch targets. As well, there is the possibility of chronic undershooting of the new target.
  2. Price-level targeting – The central bank sets a long-run target path for the price level, then manages policy to return the price level to target when it deviates. This contrasts with the current approach, under which it only targets future inflation and does not attempt to adjust for past misses. This would be complicated to communicate to the public, and make it difficult to evaluate central bank performance.
  3. Average-inflation targeting – This method involves choosing a moving window of time over which average-inflation targeting is to occur, and a target rate of inflation. Similar to Price-level targeting, this would hamper central bank communication, potentially permit excessive discretion by the central bank and, in practice, possibly make little difference to the Bank’s behaviour.
  4. Nominal-income targeting – Targeting growth in nominal income has the downside of being vulnerable to temporary and persistent shocks to the economy that affect real GDP in ways over which the Bank has no control.
  5. A dual mandate – Even in the United States, where Congress mandates that the Fed conduct monetary policy with price stability and “maximum employment” in mind, the Fed recognizes that explicit numerical goals for real economic activity (the unemployment rate, for example) would be a bad idea. The Bank already has sufficient flexibility, within the current inflation targeting framework, to mitigate negative effects on real economic activity, in the spirit of a dual mandate.

Read the Full Report

For more information contact: Stephen Williamson, Professor and Stephen A. Jarislowsky Chair in Central Banking, Department of Economics, Western University; or David Blackwood, Communications Officer, the C.D. Howe Institute, 416-873-6168, dblackwood@cdhowe.org.

The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.