Pierre Duguay: The Bank of Canada's research agenda and the future of
inflation targeting
Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to the Canadian
Association for Business Economics, Kingston, Ontario, 27 August 2007.
* * *
The last few weeks have been a time of turbulence in financial markets. In times such as
these, it is common for people to focus on day-by-day or even hour-by-hour events, and to
lose sight of the future. But tonight, I want to focus on the future; specifically, the future of
inflation targeting in Canada. I want to discuss the key issues facing us as we consider
refining our monetary policy framework in the years ahead, and to speak about the Bank of
Canada's research program in this important area. I will finish with some remarks on recent
developments in the Canadian economy and in financial markets.
Inflation targeting - room for improvement?
It may seem as if the Bank of Canada has been talking about inflation targeting forever. But
as an approach to monetary policy, inflation targeting is not all that old - less than 20 years.
In the words of economics professor Ken Kuttner, inflation targeting is still in its
adolescence.1 And like many adolescents, it still has a few issues to work out.
But let me be clear: Whatever issues there may be, our policy framework of inflation
targeting, supported by a floating exchange rate, remains the most effective approach yet
devised for conducting - and explaining - monetary policy in a country like Canada. No
central bank that has adopted inflation targeting has later abandoned it. Together with sound
fiscal policy, inflation targeting has clearly made a significant contribution to Canada's
economic welfare. Consumers and businesses have been able to manage their finances with
greater certainty about the future purchasing power of their savings and income. Economic
signals sent by movements in relative prices have been clearer, and labour markets have
been able to function better. Low and stable inflation has also meant that interest rates, both
in nominal and real terms, have been lower.
Inflation targeting has also been quite successful in anchoring inflation expectations and in
dampening economic fluctuations, owing largely to the transparency of communications that
the framework encourages. Well-anchored inflation expectations have helped to reduce the
propagation of price shocks to wages and prices and to dampen the sensitivity of inflation to
excess demand and supply. This has made the conduct of monetary policy more effective
and efficient. In effect, we've created a virtuous circle. A better monetary policy framework
has led to better inflation outcomes, increased policy credibility, and a more stable
macroeconomic environment.
Reflecting the success of the inflation-targeting regime, the government and the Bank of
Canada renewed the inflation-target agreement in November of last year for another
fiveyear period. As part of that renewal, we took the opportunity to refine and clarify our
framework, and we reached conclusions in three areas: the use of core inflation measures,
the role of asset price movements in the conduct of policy, and the appropriate time frame for
bringing inflation back to target following a shock. We concluded that we should continue to
look at measures of core inflation as a way to gauge the strength of underlying inflation,
although our target remains total CPI inflation. As for asset price movements, we will
continue to take them into account to the extent that they have implications for future
inflation. And we will continue, generally, to aim to return inflation to the 2 per cent target
over a six- to eight-quarter horizon, unless faced with shocks where a slightly shorter or
slightly longer horizon would be more appropriate. Should such a case occur, we would
communicate it transparently.
While inflation control is clearly the right assignment for monetary policy, there always
remains the question of whether the specific regime established in the 1990s will deliver the
greatest contribution to economic performance in the decades ahead. So, when the
inflationtargeting agreement was renewed last year, the Bank published a background document that
spelled out two basic questions, which we hope to answer: Is 2 per cent the right target? And
should the Bank express its target in terms of a path for the level of prices, instead of the
rate of inflation?2 Let me spend a bit of time discussing these two questions.
Is 2 per cent the right target?
When the Bank and the Government of Canada first agreed on a series of targets for inflation
in 1991, a 2 per cent rate of inflation was seen by the Bank as a step towards price stability,
which had yet to be defined. But it was also seen by most as a very ambitious target. After
all, it had been decades since the Canadian economy had experienced a sustained period
with inflation at 2 per cent or less. Indeed, during the 1980s, we had had trouble containing
inflation to 4 per cent. In addition, there were fears at the time that the introduction of the
Goods and Services Tax could rekindle inflationary pressures. But inflation quickly fell into
line following the announcement of the targets, and has averaged very close to 2 per cent
since the end of 1991.
Since then, we have seen that the economy functions better at a low rate of inflation. But this
experience raises the question: Would a lower inflation rate lead to further efficiency gains for
the Canadian economy? There are a number of reasons to think so. Lower inflation would
reduce the misallocation of resources by reducing price dispersions and making price signals
clearer. It would also reduce the costs of updating prices and the economic distortions
coming from a non-indexed tax system.
We have been researching this issue for some time. Back in 1998, the Bank published a
number of papers that examined the theoretical arguments and the empirical evidence on the
potential benefits of lower inflation, most notably a paper by McGill University's Chris Ragan
and several papers by Bank researchers.3 But it has proven difficult to quantify the expected
benefits of lower inflation. In a recent commentary, David Laidler of the C.D. Howe Institute
expresses lingering pessimism about finding material efficiency gains. He focuses instead on
the distributional benefits of lower inflation, arguing that these will take on increased
importance as our population ages and a growing number of Canadians rely on fixed
incomes.4 However, advances in modelling offer new ways of quantifying the expected
efficiency gains. These have been explored in two recent papers by Bank staff: one
coauthored with Steve Ambler - the outgoing Special Adviser at the Bank of Canada5 - the
other with Laval professor Kevin Moran.6 Their early results suggest that this is an avenue
worth pursuing further.
But while there may be benefits to be gained from a lower inflation target, there may also be
costs involved in getting there. As I mentioned earlier, Canadians' expectations of inflation
have now become firmly anchored on 2 per cent. Adjusting those expectations down to a
lower level, say 1 per cent, may not be easy, although the cost of lowering inflation
expectations can be expected to be lower than when inflation targeting was first adopted,
given the credibility that the Bank - and our inflation-targeting framework - have acquired.
However, the lengthening of non-indexed wage and debt contracts would raise some
transition costs.
Two main arguments have traditionally been advanced against the idea of targeting a lower
inflation rate. The first is the concern about downward wage rigidity: That it is more difficult to
adjust real wages downwards in an environment of very low inflation because this will likely
involve cuts to nominal wages. The second argument is that central banks could have
problems implementing a stimulative policy in a very-low-inflation environment because
nominal interest rates cannot go below zero.
With respect to downward wage rigidities, research described at the time of the 2001 renewal
of the target,7 as well as labour market developments generally, do not appear to provide a
compelling argument against a lower inflation target. But the zero-bound constraint on
interest rates remains a critical issue. The adoption of price-level targeting, however, could
help central banks deal with the zero-bound constraint. So let me now turn to the topic of
price-level targeting.
A target for the price-level path?
The essential difference between a target for the price level (which could rise over time) and
an inflation target is that under pure inflation targeting, past deviations from the target do not
have an impact on the future targeted rate of inflation. Movements in the price level that are
perceived to be "one-off" events are ignored. Bygones are bygones. But with price-level
targeting, past inflation performance does matter. If inflation had been below trend, causing
the price level to fall below target, monetary policy would need to generate above-trend
inflation for a while in order to return the price level to the target over time. Symmetrically, if
inflation had been above trend, lifting the price level above its target, the central bank would
need to bring about temporarily below-trend inflation to return the price level to its target path
over time.
Economic theory suggests that targeting a path for the price level would benefit the economy
by adding certainty about prices over the long term. This should support economic efficiency
by reducing the risks associated with long-term financial contracts. Providing added certainty
about future prices would be of particular benefit to people living on fixed incomes. And as I
mentioned earlier, price-level targeting might also help central banks avoid some of the
difficulties associated with the "zero-bound" issue. If people anticipate that the central bank
would take the appropriate measures to achieve the target, expectations about the future
price level could become very well anchored. In these circumstances, it would take smaller
moves in nominal interest rates to bring about the needed change in aggregate demand, and
hence the zero bound is less likely to become a problem. Let me explain. If a shock were to
bring the price level below the target, the anticipation that prices would return to target over
time would lower real interest rates and help boost demand, thus requiring a smaller
reduction in nominal interest rates. Put another way, the drop in prices below target would
induce buyers to take advantage of the temporarily low prices. This would alleviate the
problems posed by the zero bound.
There is, however, concern about how a central bank would need to respond to certain
shocks under price-level targeting. Under inflation targeting as it is now practised, one-off
relative price movements or changes in indirect taxes would not trigger a monetary response
as long as inflation expectations remain anchored. By focusing on the future trend of
inflation, an inflation-targeting central bank accommodates one-off shifts in the price level
and need not disturb the balance between aggregate demand and supply. But under
pricelevel targeting, persistent relative price shocks would require a monetary policy response
designed to bring about offsetting changes in other components of the consumer price index,
which may involve shifts in the balance between aggregate demand and supply. It may be
possible for a central bank to target the level of a core price index, which is less subject to
relative price movements, rather than the total index. But this could add significantly to the
communications challenges posed by price-level targeting.
These communications challenges are likely to be greater for a central bank that practises
price-level targeting than for one that practises inflation targeting. The general public can
easily relate to a well-publicized and straightforward number like the inflation rate, and to an
inflation target that remains constant over time. It could be more difficult to communicate that
the central bank's target was a particular level of a price index, which itself could be rising
over time, and that the path of inflation needed to get to this target number would change,
depending on whether the price level was above or below the target. Yet, a solid public
understanding is important if the full benefits of increased certainty about the future price
level are to be realized.
Any debate about the pros and cons of price-level targeting is bound to be based on theory,
because only one country has had any real experience with it: Sweden in the 1930s. So we
don't have much empirical evidence. That said, we now have the ability to construct the kinds
of complex economic models - multi-goods models with relative price movements - that are
important for conducting research into price-level targeting.
The Bank of Canada's research agenda
Given the nature of the questions we have regarding both a lower inflation target and
pricelevel targeting, there is a clear need for a lot of research to be done in a short period of time
if we are to have a thorough discussion of the alternatives before the next renewal in 2011.
And so the Bank has begun a concerted and ambitious research program for the next three
years.
But we know that this task is too large for us to accomplish ourselves. We very much want to
get others involved in this research agenda, so that we can benefit from their knowledge and
expertise. The Bank has held special sessions connected with meetings of various economic
groups, and we will be hosting joint conferences with other central banks, as well as our own
research conference.
The Bank has also launched a new website: www.inflationtargeting.ca. This site is intended
to be a hub where interested researchers can find out what research has been done, and
what is being planned.
At the Bank of Canada, we want to be confident that we have developed the best policy
framework to deliver on our mandate of promoting the economic and financial welfare of
Canadians. Inflation targeting has proven its worth in helping Canada achieve solid economic
performance. But it is still relatively young, and there is some room for it to grow. Over the
next few years, we hope to answer some of the lingering questions we have had about
inflation targeting.
We are not yet at the end of monetary history. With the Bank's research agenda, we hope to
write the next chapter of the story. And we hope that many others, including some of you
here tonight, will join us in that effort.
Recent economic and financial developments
Let me now turn to recent developments. I'll start with some words about the events in global
financial markets. Over the past few weeks, there has been significant turmoil in financial
markets around the world, and risk aversion has increased substantially. At the heart of the
matter has been a reassessment of risk in credit markets triggered by concern about
exposures to U.S. sub-prime mortgages. It has been extremely difficult to re-establish market
prices for certain assets, particularly highly-structured asset-backed instruments. This is due
in part to insufficient transparency - both about the actual assets that are backing these
securities and about the distribution of exposure to these assets. The difficulty for market
participants to evaluate risk and price it appropriately, together with the risk of an abrupt
correction, was highlighted in the June issue of our Financial System Review. For some time
we had been commenting that the narrow yield spreads on risky assets was raising
questions about whether risk was being priced appropriately, a concern shared by other
central bankers.
Signs of difficulty within global financial markets have been evident in the market for
assetbacked commercial paper (ABCP) and in the drying up of liquidity in money markets more
generally. Yields on short-term government debt fell sharply as investors tried to shift into
risk-free assets, and demands for liquidity put upward pressure on overnight interest rates.
Most major central banks responded by providing liquidity to support the functioning of
markets, conducting operations to reduce the upward pressure on overnight interest rates.
The Bank of Canada undertook normal open market buyback operations to provide liquidity.
It also temporarily expanded the list of collateral eligible for use by market participants in
these buyback operations to include all securities already eligible for collateral in the Large
Value Transfer System. As well, the Bank increased its supply of settlement balances as it
normally does when it sees increased demand for cash balances.
Let me emphasize that the Bank of Canada's operations to provide liquidity do not represent
a change in the stance of monetary policy, but are meant to meet increased demand for
liquidity to help re-establish well-functioning financial markets.
Within the private sector, there have been important initiatives to support the functioning of
markets. Canada's major chartered banks have confirmed that they are supporting their own
bank-sponsored asset-backed commercial paper programs. As well, a number of major
investors and liquidity providers have been pursuing an orderly restructuring for third-party
structured finance asset-backed commercial paper. These initiatives should help support the
functioning of financial markets in Canada.
Now let me conclude by turning to developments in the Canadian economy. I think it would
be useful to recall what the Bank said in the Monetary Policy Report Update (MPRU) that we
published in July. In that document, we said that economic growth and inflation in Canada in
the first half of this year had been stronger than expected, and that the economy was now
operating further above its production potential than was projected at the time of the April
Report. Our base-case projection was for average annual economic growth of about 2 1/2
per cent through 2009, slightly below our estimate of the growth rate of potential, allowing the
economy to return to its production potential in 2009. Inflation was projected to be slightly
higher than in the April Report, returning to the 2 per cent target by early 2009. We identified
both upside and downside risks to our inflation projection, noting that these appeared to be
roughly balanced. The main upside risk related to the strength of household spending. The
main downside risks related to the effects on the Canadian economy of the stronger
Canadian dollar and of the ongoing adjustment in the U.S. housing sector. We increased our
key policy interest rate to 4 1/2 per cent on 10 July, and said at that time that in line with our
outlook, some modest further increase in the policy rate may be required.
MPRU
Economic data published since the July have been roughly in line with expectations.
Domestic demand in Canada has remained robust, against the backdrop of strong labour
and housing markets. But given recent events in global credit markets, we need to assess
the extent to which the risks around our July projection have shifted. Specifically, we are
asking ourselves two questions: First, how much greater is the risk to the Canadian economy
now posed by developments in the U.S. economy? And second, to what extent would the
repricing of credit risk lead to a sustained tightening of credit conditions in Canada?
We will be considering these questions as we prepare for our next interest rate
announcement on 5 September.