Mr. Thiessen discusses the Canadian experience with targets for inflation
Text of the 1998 Gibson Lecture by the Governor of the Bank of Canada, Mr. Gordon
control
Thiessen, at Queen's University in Kingston, Ontario on 15/10/98 (charts and references
omitted).
It is an honour to have been asked by the School of Policy Studies and the John
Deutsch Institute to deliver the 1998 Gibson Lecture.
As an economist who worked as a banker for most of his career, Douglas Gibson
brought an interesting perspective to public policy issues, to the relationship between
government and business, and to the contribution of outside economists to government policies. I
noted with particular interest a comment by Gibson in his 1981 essay in honour of John Deutsch.
He points out that few academic economists in Canada up to that time "appeared to appreciate
the destructive influence of inflation on the economy and on society".1
That comment provides a convenient link to my topic for this year's Gibson
Lecture. What I propose to do is to reflect on Canada's experience using explicit targets aimed at
low rates of inflation as the focus for conducting monetary policy.2 But let me first set the scene
by putting the inflation targets in the context of various approaches to monetary policy.
With the sharp rise in worldwide inflation in the 1970s, the costs of inflation
became more and more evident. Consequently, central banks increasingly focused their attention
on how to get inflation down and keep it down. One lesson that came out of this period was the
importance of having some sort of "nominal anchor" to ensure that monetary policy does not lose
sight of the objective of inflation control, given the long lags in the operation of monetary
policy.3
The traditional nominal anchor for small countries has been a fixed exchange rate
that links the currency of the small country to that of a larger trading partner that has been
successful in controlling inflation. Among the larger countries, many central banks turned to
monetary aggregates as an intermediate target for monetary policy around the mid-1970s as
relatively high inflation became entrenched in the world economy. Subsequently, with inflation
and inflation expectations persisting at uncomfortable levels in many countries during the 1980s,
the policy innovation in the early 1990s was the introduction of explicit inflation-control targets
in eight countries.4
The main factor that countries choosing to use explicit inflation-control targets
have in common is a history of higher-than-average inflation. In some cases, they had previously
used monetary aggregates and/or a fixed exchange rate without success or with only limited
success. And, unlike countries with a history of relatively low inflation (such as the United
1
Gibson (1981).
2
Broad assessments of the experience to date with inflation targeting in industrial countries can
be found in Almeida and Goodhart (1998) and Bernanke et al. (1998). Individual country experiences can be found
in Leiderman and Svensson (1995). For an assessment of the potential advantages and disadvantages of inflation
targeting in developing countries, see Masson et al. (1997).
3
See Bouey (1982).
4
New Zealand, Canada, the United Kingdom, Sweden, Finland, Australia, Israel and Spain
adopted inflation targets in the first half of the 1990s.
States, Germany and Japan), the history and consequent problems of policy credibility in
inflation-targeting countries meant that they were unable to rely upon a general qualitative
commitment to low inflation.
The key objectives of Canada's inflation targets, when they were originally
announced in 1991, were to prevent inflation from accelerating in the short run in the face of the
introduction of the new Goods and Services Tax (GST) and a sharp rise in oil prices and, in the
longer run, to bring inflation down to a level consistent with price stability. Over time, the
importance of other favourable characteristics of inflation targets as a permanent operating
framework for monetary policy has become increasingly apparent to us at the Bank of Canada.
The most notable of these characteristics are increased transparency, better accountability,
improved internal decision-making, and a mechanism for responding to demand and supply
shocks that reduces potential fluctuations in output.
I would not argue that explicit inflation targets are the only way to achieve good
macroeconomic results. Indeed, the worldwide reduction of inflation in the 1990s across
countries with different frameworks for monetary policy clearly indicates that there are a number
of ways to achieve low inflation. Rather, I will argue that explicit inflation targets bring a
discipline to monetary policy that is helpful in providing a more stable and predictable
environment for the economic decisions of businesses and individuals. Moreover, I believe that
the benefits of the clear operating framework provided by such targets will make them
increasingly attractive in democratic societies that demand accountable public institutions.
I will begin this lecture with a brief history of inflation targets in Canada and go
on to an assessment of the performance of the Canadian economy during the period in which
inflation targets have been in place. I will then turn to a discussion of the favourable
characteristics of inflation targets, over and above achieving a low rate of inflation. After
examining the main criticisms of explicit targets for low inflation, I will offer some concluding
remarks about the contributions that the targets have made to the conduct of monetary policy in
Canada over the last eight years.
A brief history of inflation targets in Canada
In response to the persistence of high inflation during the 1970s, the Bank of
Canada adopted a narrowly defined monetary aggregate (M1) as a target in 1975. When this
aggregate became increasingly unreliable and turned out not to have been all that helpful in
achieving the desired lessening of inflation pressures, it was eventually dropped as a target in
1982. Subsequently, the Bank embarked on a protracted empirical search for an alternative
monetary aggregate target, but no aggregate was found that would be suitable as a formal target.
Thus, from 1982 to 1991, monetary policy in Canada was carried out with price stability as the
longer-term goal and inflation containment as the shorter-term goal, but without intermediate
targets or a specified path to the longer-term objective.
In February 1991, explicit targets for reducing inflation were introduced through
joint announcements by the Bank and the federal government.5 These announcements confirmed
price stability as the appropriate long-term objective for monetary policy in Canada and specified
a target path to low inflation. The first guidepost was set for the end of 1992 at a target rate of 3
per cent for the 12-month increase in the consumer price index (CPI). This was to be followed by
a reduction to 2.5 per cent for mid-1994 and to 2 per cent by the end of 1995. These targets had a
band of plus and minus 1 percentage point around them. The announcements specified that after
1995 there would be further reductions of inflation until price stability was achieved.
At the time the targets were announced, there was upward pressure on prices in
Canada from two major shocks -- the sharp rise in oil prices following the Iraqi invasion of
Kuwait and the effect on the price level of replacing the existing federal sales tax at the
manufacturers' level by the broader-based GST. These shocks had led the Bank and the
government to be concerned about a deterioration of inflation expectations and the possibility of
additional ongoing upward pressure on wages and prices. The fact that Canada had recently gone
through a period of inflationary pressure induced by excess demand added to those concerns. By
providing a clear indication of the downward path for inflation over the medium term, the key
near-term aim of the targets was to help firms and individuals see beyond these price shocks to
the underlying downward trend of inflation at which monetary policy was aiming, and to take
this into account in their economic decision-making.
In the longer term, the inflation-reduction targets were designed to make more
concrete the commitment of the authorities to the goal of achieving and maintaining price
stability. In addition, by providing information on the specific objectives to which the Bank's
monetary policy actions would be directed, the targets were intended to make those actions more
readily understandable to financial market participants and to the general public. In this way, the
targets would provide a better basis than before for judging the performance of monetary policy.
In December 1993, on the occasion of the announcement of my appointment as
Governor, the Bank and the Minister of Finance issued a joint statement on the objectives of
monetary policy. In this statement, the newly elected government and the Bank recommitted
themselves to price stability as the goal of monetary policy. It was also agreed that the 1 to 3 per
cent target range for inflation would be extended through 1998, and that a decision on the
definition of price stability would be postponed. There were two reasons for this extension. First,
because it had been a long time since Canada had had low rates of inflation, it was felt that more
experience in operating under such conditions would be helpful before a long-term objective was
set. Second, since inflation had dropped rather dramatically and unexpectedly during 1991, it was
unlikely that Canadians had completely adjusted to the improved inflation situation. More time
was therefore needed to make that adjustment before announcing any further changes to the
target.
In February 1998, the government and the Bank announced that the 1 to 3 per cent
target range would be extended again, this time to the end of 2001. This extension reflected the
fact that the economy had not yet reached full capacity in the current cyclical upswing. It would,
therefore, be helpful to have the economy demonstrate more fully its ability to perform well
under conditions of low inflation before determining the appropriate long-run target consistent
with price stability. The government and the Bank now plan to determine this long-run target
before the end of 2001.
Inflation targets and economic performance in Canada
What did we expect in the way of economic performance from the inflation
targets? First, we expected a lower rate of inflation and reduced inflation expectations. Second,
the achievement of a lower inflation rate and the commitment embodied in the targets to
maintain that lower inflation rate were expected to result in lower interest rates. Third, with
lower inflation, we anticipated that the economy would function more efficiently and without the
sharp fluctuations caused by inflationary booms and subsequent recessions.6
What has the outcome been thus far?
Chart 1 shows the rate of inflation over the period of inflation targets. Following
the initial announcement of the targets in February 1991 (when the 12-month rate of increase in
the total CPI was at 6.8 per cent), inflation fell rapidly. Indeed, for much of 1992 it was below
the bottom of the target range. Since then, with the exception of a brief period in 1995, the trend
of inflation has been in the lower half of the target range.
The speed of the decline in inflation during 1991 was surprising. It reflected a
much more severe economic slowdown than either the Bank or most other forecasters had
expected. In part, the depth of the 1990-91 recession was due to international factors, such as
lower-than-expected growth in the United States and an unexpectedly sharp decline in raw
materials prices. But in Canada, it also reflected the unwinding of distortions in asset prices and
debt accumulations associated with the preceding period of inflationary pressures.
It is unlikely that the 1991 announcement of the path for inflation reduction had a
significant immediate impact on the expectations of individuals, businesses, or financial market
participants. On balance, I think that it is the low realized trend rate of inflation in Canada since
1992 that has been the major factor in shifting expectations of inflation downwards. But the
targets have probably played a role in convincing the public and the markets that the Bank would
persevere in its commitment to maintain inflation at the low rates that had been achieved.
Moreover, there are some recent indications that the 2 per cent mid-point of our target range is
becoming an important anchor for current expectations and for long-range corporate planning.
If we examine interest rates and the growth of output and employment over the
period of inflation targets, the first point to note is that the recovery from the 1990-91 recession
was less vigorous than typical in the post-war period. The growth of domestic demand, in
particular, was subdued until mid-1996 (see Chart 2).
Moreover, the economic expansion in Canada was considerably less robust than
that in the United States. While some observers have attributed the sluggishness of the recovery
to the adoption of inflation targets and the associated conduct of monetary policy, this criticism
overlooks the major restructuring that took place in Canada in both the private and public sectors
over this period.7 Whereas the United States had undergone a period of intense private sector
restructuring starting in the mid-1980s, the corresponding Canadian restructuring did not take
place until the first half of the 1990s. At about the same time, after two decades of continuous
fiscal deficits and public sector debt accumulation in Canada, unprecedented corrective actions
were required to put public finances onto a sounder path.
Both sets of actions were essential to move Canada towards a better-functioning
economy. The short-run consequences, however, included a weak employment situation and an
associated lack of consumer confidence. And these resulted in sluggish domestic demand and a
weaker-than-expected recovery in the Canadian economy.
Monetary conditions were easing through much of this period.8 However, for quite
a long time the Bank was unable to provide as much monetary stimulus as it would have liked
because of fiscal, political, and international developments that, at times, caused financial
markets to be nervous and volatile. It was only after 1995, with improved credibility on the fiscal
front and subsequent to the Quebec referendum campaign, that the Bank was able to achieve a
durable reduction in short-term interest rates. As the credibility of both monetary and fiscal
policy improved, Canadian interest rates across the maturity spectrum moved to levels below
comparable interest rates in the United States. In response to easier monetary conditions,
domestic demand in Canada recovered, with a strong expansion beginning in mid-1996 and
continuing through 1997.
One of the main conclusions that I would draw from the Canadian experience of
the 1990s is that, while low inflation is necessary for good economic performance, it is not
sufficient by itself. While monetary policy was able to achieve a rate of inflation that was within
the target range for most of the period, other factors also played an important role in determining
interest rate movements and output and employment growth.
Does the important role played by non-monetary factors mean that the inflation
targets and the low rate of inflation were not helpful? Not at all. The ability of businesses to
undertake a major restructuring was greatly enhanced by the stable low-inflation environment.
And while fiscal and political uncertainty resulted in appreciable financial market volatility, as
well as vulnerability to external shocks in the period before 1996,9 I believe that the situation
would have been considerably worse without the anchor provided by low inflation and the
inflation targets. And, in conjunction with improved fiscal policy, they have facilitated better
economic performance in the more recent period and have allowed us to weather the current
international financial problems with fewer difficulties than before. Targets should continue to
provide a sound foundation for good economic performance and for coping with the international
shocks that are bound to hit us from time to time.
Increased monetary policy transparency and accountability
When the government and the Bank agreed on the initial targets in 1991, the main
concern was to lay out a path for the reduction of inflation on the way to price stability. Despite
the emphasis that the Bank had for some years placed on price stability as the objective of
monetary policy,10 the period over which the objective was to be achieved was a source of
uncertainty among the public. Thus, one of the key benefits of the targets was expected to be
increased transparency with respect to the objective of monetary policy, leading to a reduction of
public and financial market uncertainty.
The announcement in 1991 also noted that the targets should provide a better basis
for judging the performance of monetary policy. Criticisms of monetary policy had often
implicitly assumed that the Bank should be pursuing policy objectives other than price stability.
By setting out a clear objective, and with the commitment of the government to that objective,
the Bank hoped that future public assessments of monetary policy performance would focus
more clearly on its record of achieving price stability.
There is no question that explicit targets for inflation control make the objective of
monetary policy more transparent and provide a better basis than before for holding the central
bank accountable for its conduct of monetary policy. I have not tried to pull together evidence
that, with a clearer objective, public commentary on monetary policy since 1991 has involved
fairer assessments of the performance of the Bank of Canada. And it is difficult to demonstrate
conclusively that, overall, financial and economic uncertainty in Canada have been less than they
would have been without targets. Nonetheless, it is my qualitative assessment that those
improvements have taken place.
And the targets have certainly had a major impact on the Bank itself.
With respect to transparency, we found that explicit targets provided a strong
incentive that encouraged us to become more forthcoming about how we would operate to
achieve those targets. As I have discussed elsewhere,11 we have taken initiatives to explain more
fully our assessment of economic developments and our outlook for output and inflation. We
have clarified how we make judgments about the actions needed to achieve the inflation target,
and how we operate in markets to implement those judgments.
Moreover, the Bank's senior staff now spends much more time than before on
public explanations and discussions across the country about monetary policy and central bank
operations.
All these initiatives were designed to make the implementation of monetary policy
and the achievement of the targets more effective.
Explanations and discussions are also part of the process whereby the Bank is
accountable to the public for its actions. Accountability implies that the central bank must either
achieve the target or explain what unanticipated events caused it to miss the target and what it is
doing to rectify the situation. Thus, we have a strong incentive to ensure that the public is well
informed about the circumstances that could affect our achievement of the objective.
It is not surprising that in some countries inflation targets and increased autonomy
for the central bank have gone hand in hand. An autonomous central bank has traditionally fitted
somewhat awkwardly into a democratic society.12 However, once targets are set and the central
bank is charged with achieving those targets, it is much more feasible for Parliament and the
public to hold the managers of monetary policy to account for their performance.
In Canada, no new arrangements for central bank accountability have been put in
place since 1991. But in fact the existing arrangements have adapted quite well to an
inflationtargeting environment. The Bank of Canada Act gives the Bank's Board of Directors the
responsibility for ensuring that the institution is well run.13 This includes assessing the
performance of the Governor and of the other members of the Governing Council, who are
responsible for managing the Bank.14
The inflation targets have made those performance assessments more
straightforward. When it comes to monetary policy -- the Bank's most important responsibility
-there is now a clear measure of what constitutes successful performance.
The second part of the accountability arrangement for the Bank of Canada is the
directive power given to the Minister of Finance under Section 14 of the Bank of Canada Act.
With the new practice of agreed targets between the Bank and the Minister, the directive power,
which has never been used, now seems even less likely to be used. Nonetheless, if there were a
fundamental disagreement on the targets when they came up for renewal, the Minister could
impose his will via a directive. That would likely lead to the Governor's resignation and a new
Governor, who was prepared to accept the desired targets, would have to be chosen.15
As long as no directive is in force, the Bank must take full responsibility for its
monetary policy actions. However, this directive power implies that the Minister must also take a
broad, ultimate responsibility because he has the power to change monetary policy. Quite
evidently, this is a power to be used only in extreme circumstances. Nevertheless, this
arrangement defines the nature of the Bank's relationship to the Minister of Finance in the area of
monetary policy.
In today's world, the accountability of public institutions goes beyond traditional
legislated arrangements. In democratic societies, the general public now demands much more
information and accountability for performance from public institutions. Here again, by
establishing a clear performance objective, the inflation-control targets have made it easier for
the Bank to account for its stewardship to Parliament and the general public.
Improved internal decision-making
The explicit target for policy and the associated increase in transparency and
accountability of the Bank of Canada have also had an impact on our internal decision-making
processes.
Other central banks that have adopted inflation targets have also noted the
improvement in the process of internal decision-making that has resulted.16 The improved
decision-making can be attributed largely to the focus on a clear objective and the consequent
need to develop a robust framework that maximizes the likelihood of realizing that objective in
the light of the long lags between monetary policy actions and their effects on inflation.
The inflation-targeting framework typically has a number of components -- a
procedure for projecting the future rate of inflation, a set of quantitative estimates of the
relationships that link the central bank actions and the rate of inflation, and the development of
information variables that provide early warning to the authorities that economic and financial
events are, or are not, proceeding in line with the inflation outlook.
In Canada, the policy process works as follows. The Bank makes a projection of
inflation one to two years ahead. This is based in large part on our assessment of international
and domestic economic developments and their implications for the path of real output in the
Canadian economy relative to potential output. In this framework, minimizing the difference
between the projected rate of inflation six to eight quarters in the future and the target rate
becomes the effective intermediate objective for monetary policy.17 A full projection is
undertaken every quarter, reassessed mid-quarter and carefully monitored in between. The idea is
to re-examine the scenarios on which policy actions are based as new information becomes
available. In this context, I would note that we are very aware of the uncertainty surrounding both
the projection and the transmission mechanism that links our actions to demand and inflation.18
While it is still early to offer any definitive judgments, I would suggest that so far
one of the most important results of the targets has been an increase in the internal discipline of
the policy-making process. The Bank's commitment to the targets and the need to explain and
justify any inability to meet the targets have resulted in a better-focused internal debate on the
appropriate policy actions to take and has probably reduced the likelihood that decisions to take
such actions will be put off.
The response to demand and supply shocks under inflation targeting
In addition to their positive effects on transparency, accountability and
decision-making, the inflation targets also provide a mechanism that helps monetary policy to
deal with demand and supply shocks in a way that reduces economic fluctuations.
If the inflation forecast suggested that aggregate demand was expanding at an
unsustainable rate and would be pressing on capacity so that the trend of inflation would likely
go through the top of the target range, the Bank would tighten monetary conditions to offset the
demand and inflationary pressures. Conversely, if demand was weak relative to capacity and the
trend of inflation looked likely to move below the bottom of the range, the Bank would ease
monetary conditions, thereby providing stimulus to the economy and reducing the downward
pressure on inflation. By operating in this way, the Bank effectively reduces the magnitude of the
fluctuations in real output and income that are inherent in a market-based economy. Because of
this economic-stabilizer characteristic of targets in response to demand shocks, and the helpful
role of the top and bottom of the range in communicating the way in which the Bank responds to
such shocks, the Bank has recently been giving more emphasis to the target range than was the
case initially.
Moreover, to the extent that explicit targets and their successful achievement give
Canadian monetary policy more credibility, the Bank of Canada has more potential room for
manoeuvre in dealing with demand shocks. For example, following an upward demand shock,
policy credibility can give the Bank more room to see how large and how long-lived the shock is
likely to be and how much pressure it seems to be putting on the economy's capacity to produce.
The Bank will have this greater latitude only insofar as inflation expectations are more firmly
anchored by the targets and are not dislodged by a delay in responding to a shock.19
Inflation targets have also turned out to be helpful in dealing with certain types of
supply shocks. For temporary shocks to food and energy prices, our operational focus on a core
rate of inflation (the CPI excluding food, energy and the effect of changes in indirect taxes)
makes it clear that the focus of monetary policy is on the trend of inflation and not on such
temporary fluctuations.
Removing indirect taxes from our core measure of inflation implies that the Bank
will accommodate first-round effects of tax changes on the price level. However, we have also
made it clear that we would not accommodate any ongoing inflation effects that might come
from attempts to adjust salaries and wages to seek compensation for tax increases.
Another type of supply shock that may become relevant in the period ahead is the
possibility that the widespread restructuring that we have seen in the Canadian economy, along
with new technology and high levels of business investment, will lead to growth rates and levels
of potential output higher than currently estimated on the basis of past experience. In such an
event, the economy will be able to expand faster and operate at higher levels of output than
previously thought without generating inflation pressures.
A credible inflation target can help the Bank probe to find out where the limits of
potential output really are. Consider a case where inflation remains under downward pressure
even as the economy operates at levels of activity that the Bank believes to be consistent with
full capacity. The risk of having inflation go below the target, and the accountability issues that
this would raise, should ensure that the Bank will not make persistent errors in underestimating
potential output.20
This operational framework should help to make clear to Canadians that a
monetary policy focused on inflation targets does not ignore fluctuations in employment and
output, or result in a persistently underperforming economy.
Some criticisms of targeting low inflation
Let me now turn to the main criticisms that have been levelled at the Bank's
targets for low inflation. They are: the possibility of downward rigidity in nominal wages; the
floor of zero on nominal interest rates; and a concern about deflation. You will note that none of
these criticisms is directed at inflation targeting as such, but at the choice of a target for inflation
control that is very low.
Wage rigidity
Are wages rigid to the degree that they would be slow to decline even in the face
of slack in the labour market? And what are the implications of such a situation for the working
of the economy and for monetary policy? In other words, is some level of inflation needed to
"grease the wheels" of the economy and eliminate the potential effect of such rigidity?21
The evidence thus far, although still fragmentary, suggests that wages can and do
decline.22 It is also worth emphasizing that, with positive productivity growth, the average wage
will normally rise over time even in an environment of stable prices. In such circumstances,
unchanged nominal wages will enable a decline in unit labour costs equal to the rate of
productivity growth, if such a decline is needed.
Furthermore, the resistance to downward adjustments of nominal wages that built
up during the period of high inflation is likely to lessen as the public becomes accustomed to low
inflation. Given that the behaviour of nominal wages adjusted to the period of high inflation
starting in the 1970s, I see no reason why it will not adjust equally to the current period of low
inflation. Indeed, there is now some evidence, in Canada and in other low-inflation countries, of
an increase in the relative importance of variable pay schemes (bonuses, etc.) as opposed to
increases in base wage rates.23 If sustained, this development would help to increase wage
flexibility.
As I have said in the past, I have a great deal of difficulty with the idea that wage
earners in Canada are subject to a permanent money illusion that can, and should, be exploited by
the monetary authority.24
How can monetary policy be eased when inflation is very low and interest rates
are close to zero?
One of the criticisms of the goal of price stability, or a very low inflation rate, is
that it rules out using negative real interest rates (i.e. interest rates lower than the rate of
inflation) to provide stimulus to the economy should this become necessary. This line of
argument implies that one should avoid targeting a very low rate of inflation because of the
added flexibility that the possibility of having negative real interest rates gives to policy-makers
at a time of economic weakness.
In assessing this criticism, it is important to remember that the achievement of
price stability is likely to lead to a lessening in the amplitude of business cycle fluctuations. In
the post-war period, deep recessions (of the sort that might, in extreme cases, call for negative
real rates) have typically been preceded by periods of strong inflation pressures. These pressures
resulted in significant economic distortions, which, in turn, affected the depth of the subsequent
downturn. In the absence of such inflationary distortions, the downturns are likely to be much
milder. Hence, there is less likelihood that a period of negative real interest rates would ever be
called for.
Moreover, while nominal short-term interest rates cannot be less than zero, it is
worth underlining that a near-zero nominal rate will still imply a real interest rate that is
appreciably below its equilibrium value and will provide considerable stimulus to the economy.
Finally, in a small open economy with a flexible exchange rate regime, monetary
conditions can become easier as a result of both interest rate and exchange rate movements. Even
if there were only limited easin