Stephen S Poloz: 25 years of inflation targets - certainty for
uncertain times
Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Business Council of
British Columbia, Vancouver, British Columbia, 1 November 2016.
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Introduction
These are uncertain times in the global economy, and anything that can be done to lessen
uncertainty is welcome. Last week, the Bank of Canada and the federal government took an
important step to provide some certainty, to both companies and consumers, by signing a
fiveyear renewal of our inflation-targeting agreement.
This year marks the 25th anniversary of inflation targeting in Canada. That is a long time-so
long that a whole generation of business leaders and consumers has not had to deal with the
uncertainty associated with high and variable inflation. It is human nature to take for granted
things that have been around for a while. The Bank of Canada will never take for granted the
benefits of inflation targeting, and last week's renewal makes it timely to remind people of the
benefits that inflation targeting has delivered, as well as the difficult journey we took to get here.
Finding an Anchor
Twenty-five years is the silver anniversary, but inflation targeting has truly been golden. As an
approach to monetary policy, inflation targeting has proven its worth repeatedly, both in good
economic times as well as turbulent ones. Canada was just the second country to adopt this
approach. Now, inflation targeting-narrowly defined-is being practised by 36 central banks
representing 37 per cent of the world's economy. When you add the US Federal Reserve, which
has inflation control as one of its mandates, and the European Central Bank, which has a
mandate to keep inflation below 2 per cent, 64 per cent of the world economy is following some
form of inflation targeting.
But to understand how important an advance this system represents, you need to look back to
the bad old days of the 1970s and 1980s. Inflation was not only much higher than today, but it
was also much more variable. Annual inflation reached more than 12 per cent in 1974, dropped
to less than 6 per cent two years later, then jumped back to over 12 per cent in 1981.
It was impossible to predict with confidence what the inflation rate would be from one year to the
next. From an employer's point of view, high and variable inflation made it extremely difficult to do
the hard math required to run a business. High inflation meant companies constantly faced
"menu costs" associated with having to regularly adjust prices. Those costs would typically be
passed on to consumers, who also faced uncertainty about the future purchasing power of their
savings.
The situation was bad enough in the 1970s that the federal government implemented wage and
price controls-a drastic measure usually reserved for times of war. They did not work. What
ultimately did work were extreme monetary measures-interest rates that would make your head
spin today. Mortgage rates rose above 20 per cent in the late 1970s. That must be hard to
imagine for the current generation of borrowers, who are accustomed to five-year mortgages
below 3 per cent and zero per cent financing at car dealerships.
That necessary monetary medicine was painful, and it worked. By 1983, inflation had settled into
a range of around 4 to 5 per cent. Back then, it would have been easy to proclaim the mission
accomplished. Lowering inflation was no longer a high priority for governments, or for employees
-particularly unionized workers-who could protect themselves with cost-of-living adjustments
built into contracts.
It was about this time that I first came to work at the Bank of Canada. We knew that settling for 4
to 5 per cent inflation was not good enough. Canadians would still have their purchasing power
eroded, just not as quickly. At an inflation rate of 5 per cent, prices still double in 15 years-which
means that prices would more than double over someone's retirement horizon.
Back in the late 1970s, there was a near-absolute consensus among economists and
academics about how central banks should fight inflation. Control the supply of money and you
control inflation, or so the theory went. Monetary targets would give clarity-a nominal anchor to
help explain your actions-and provide the inflation outcome you want. Everyone understood
that. The only problem was, it did not work quite as the theory predicted.
We worked hard at the Bank to try to save the idea of monetary targets, but the economy was
changing rapidly, and new types of bank deposits were being introduced. As a result, the
relationship between money supply and inflation proved too unpredictable to rely on. It was quite
a blow to the economics profession when, in 1982, then-Governor Gerald Bouey famously
dropped the bombshell that we would no longer target the money supply. The Bank went off into
uncharted academic territory, searching for a new way to control inflation.
We knew all along that interest rates and inflation are connected through a complex series of
relationships, with money somewhere in the middle. So, the Bank focused its efforts on refining
its understanding of the linkages between interest rates, economic growth and, ultimately,
inflation-in short, a macroeconomic model. In 1988, then-Governor John Crow announced that
monetary policy should aim at "achieving and maintaining stable prices." Although the precise
definition of price stability was left open, the anchor for monetary policy would be inflation itself,
not an intermediate variable such as money.
It is fair to say that the concept of directly targeting inflation was met with a fair degree of
skepticism, including from the government. After all, a central bank does not control how prices
are set. What made us think we could achieve an inflation target? Well, we had done the
research and improved our ability to use economic models, so we knew the logic was sound. In
the end, the federal government was persuaded-we reached a formal agreement that said our
monetary policy would be directed at controlling inflation and that gave us the operational
independence to carry out policy as we saw fit.
And so, in 1991, Canada became an inflation-targeting pioneer. Over time, the broad parameters
of our approach have not changed. For the first three years, we had inflation-reduction targets,
with a goal of bringing inflation down to 2 per cent. We succeeded. Since 1995, we have aimed
to keep inflation at the 2 per cent midpoint of a 1 to 3 per cent range. Importantly, we approach
the target symmetrically. Given the experiences of countries who have struggled with deflation,
we are just as concerned about inflation below our target as above it. We want businesses and
consumers to be able to make long-term plans with certainty.
Reaping the Rewards
As it turned out, the framework worked better than we could have reasonably hoped. Check the
numbers. Inflation averaged about 7 per cent between 1975 and 1991, including the 1983 to 1990
period when it stabilized around 4 to 5 per cent. Since then, inflation has averaged almost exactly
2 per cent and become much more stable, and expectations have become solidly anchored on
the target.
Inflation targeting has also provided economic benefits that went beyond those we were
expecting. Canadian businesses and households have reaped the rewards of reduced
uncertainty, helping them make spending and investment decisions with more confidence. It has
also led to improved economic performance across a number of dimensions-both in terms of
higher levels of activity and lower variability.
The agreement, which has been renewed every five years since 2001, gives our approach
legitimacy-that is crucial in a democratic society. And having an explicit number for a clear
target like the inflation rate makes it easy to judge our work. Importantly, the agreement also
gives inflation targeting additional credibility, which has made it more effective. This credibility has
grown with our success in hitting the target.
The combination of inflation targeting with a floating exchange rate has given Canada scope to
pursue a truly independent monetary policy, suited to our specific conditions. The framework has
also given us flexibility to respond to economic shocks. We could act aggressively during the
global financial crisis, for example, because inflation expectations were so well anchored. And,
during the crisis, our framework provided an anchor that helped explain our actions.
It was not just Canada that benefited from improved economic performance. This outcome was
shared by many countries as inflation targeting spread, contributing to a period known as the
"Great Moderation." That success had a downside-the extended period of positive economic
performance spawned rising financial imbalances. In short, we learned that while inflation
targeting can bring about economic stability, that is not a sufficient condition for financial stability.
Let me mention one more important benefit of our framework. Inflation targeting has made the
Bank of Canada much more transparent.
From the beginning, we knew that inflation expectations would be important. If people believed we
would bring about low and stable inflation, they would behave in a way that would help make that
happen. It has become clear over 25 years that it is easier to anchor inflation expectations when
people understand what the central bank is doing, and why. This has led to a steady evolution in
our approach to communications-in short, more and deeper communications around monetary
policy decisions.
In Governor Bouey's day, communication with the public was not a high priority. One or two
public speeches a year was normal, with an occasional one by a Deputy Governor. So far this
year, Governing Council members have given 17 public addresses, like this one, each broadcast
live over the Internet and posted on our website for future reference.
There have been many other changes that make us more transparent and accountable. Four
years after moving to inflation targets, we began publishing our Monetary Policy Report (MPR),
which explains in detail how we interpret developments in the economy and spells out our
economic and inflation forecasts. Senior Deputy Governor Wilkins and I hold press conferences
after the publication of each issue of our MPR and Financial System Review, and we offer
opening statements that highlight the key issues that figured in our policy deliberations. The two
of us also appear before House of Commons and Senate committees twice a year. The Bank
now publishes more research and has become active on social media. The overarching goal of
all this activity is to help Canadians understand what we are doing, and why.
Of course, Canada is not alone in this move toward transparency. My belief is that the additional
accountability that comes with a formal inflation target has been the main driver of the
transparency trend seen here and at other central banks.
Adjusting the Paradigm
Now, just because inflation targeting has worked very well, that does not mean it cannot be
improved. At each renewal, we have asked ourselves fundamental questions to make sure
inflation targeting is delivering economic benefits most effectively. For example, in 2011, we
clarified that the framework gives us the flexibility to adjust the time we need to return inflation to
target, if moving too quickly or slowly would worsen financial stability concerns.
During the five years leading up to this renewal, we looked into three issues. The first was about
as fundamental as you can get: Is 2 per cent the right target? This has been a live issue
throughout our experience with inflation targets. Five years ago, our research considered
whether we should lower the target. This time, given our experience with low inflation and the risk
of deflation, we took a good look at the idea of raising the target.
We considered this possibility seriously because central bank policy rates in many economies
have been near, or at, historic lows, reaching the effective lower bound in some places. The idea
is that interest rates would generally be higher if we had a higher inflation target, so we would
have more room to lower rates in the future before we hit that effective lower bound.
However, we have learned from recent experience that there are unconventional monetary
policies that give us more room to manoeuvre than previously believed. These include pushing
interest rates below zero or buying longer-term bonds to compress long-term yields. A higher
inflation target would mean higher nominal interest rates and more room to manoeuvre, on
average, but also would entail imposing a higher inflation tax on the economy. I think of this as
paying dearly, every day, for insurance against the low-probability risk that another very large
macroeconomic shock could occur in the future. Besides, pushing inflation up from 2 per cent to
3 per cent might be quite difficult to do, and might require some significant economic fluctuations,
given how well inflation expectations appear to be anchored at 2 per cent.
The second issue we focused on was our measure of core inflation. Prices can move for
reasons beyond the control of monetary policy. For example, a drought can lead to higher food
prices. We try to look past those movements to focus on the underlying trend of inflation, so that
we do not oversteer our policy. Previously, we used one particular measure of core inflation.
Now, we will use three different measures that get at the underlying trend in different ways. You
can find more information about these measures in the renewal document that is posted on our
website.
The third issue we took on is how monetary policy decisions should take into account concerns
about the stability of the financial system. Once again, we drew heavily on the experience of the
past five years. We have now seen successive moves by federal authorities to mitigate the
threat posed by imbalances in our housing market and high levels of household debt. Our view is
that these so-called macroprudential policies are best placed to deal with threats to financial
stability because they can be designed to target specific financial vulnerabilities. In contrast,
adjusting interest rates is a very blunt tool with widespread effects. Given all the work done to
strengthen the global financial system over the past few years, it makes even more sense to
separate monetary policy from efforts to stabilize the financial system.
That does not mean our monetary policy ignores financial stability issues. For one thing,
monetary policy is transmitted through the financial system, so we want it to work well. For
another, we know that financial system vulnerabilities can magnify the impact of negative shocks,
such as a large rise in unemployment. So, at the Bank of Canada, we take a risk-management
approach to monetary policy. We acknowledge that there is always uncertainty around the
outlook for inflation, and developments in the financial system bring uncertainties for financial
stability. These uncertainties generate a zone within which we can tolerate variations in either the
risks to our inflation outlook or risks to financial stability. Because there are many possible paths
for monetary policy that can lead us to our inflation target, and because we have flexibility around
the time it takes to hit the target, we can use monetary policy to manage those risks, while still
keeping the pursuit of our inflation target as our main priority.
The Future of Inflation Targeting
For me, renewing the inflation target is a cause for celebration. And, I think Canada's inflation-
targeting framework is stronger than those in many other countries, for a few reasons.
First, the five-year renewal cycle gives us a regular opportunity to do a thorough examination of
our policy in light of experience and new research, and to adjust it if necessary. Without the
regular renewals, it would be much more difficult to introduce new thinking into the framework.
Second, the renewal cycle brings an obligation to demonstrate to the government and to
Canadians that we have the right policy. This requirement means that the framework has strong
credibility.
Third, because the framework takes the form of an agreement between the government and the
central bank, there is an explicit commitment from the government to support our pursuit of low,
stable and predictable inflation. The agreement therefore means that all economic policies-
including monetary, fiscal and macroprudential-can work together in a complementary fashion.
But at the same time, I recognize that even after years of very low interest rates, the economic
recovery in many economies remains weak. So it is not really surprising that some are
questioning whether policy-makers, including central bankers, are doing the right thing. Has
monetary policy lost its effectiveness? Is inflation targeting passé?
We take these debates seriously. We have studied the research and the theory behind
frameworks such as price-level targeting and targeting the growth of nominal gross domestic
product. But, to date, we have not seen convincing evidence that there is an approach that is
better than our inflation targets.
I am in no way suggesting that inflation targeting is perfect. We will never stop looking for ways to
make our framework better, and to provide greater certainty to Canadian businesses and
consumers. This goes beyond the targets themselves to include the tools we use to pursue
them. Economic models remain at the core of the entire inflation-targeting process, and models
require investments to capture many new complexities in today's economies. In short, the next
generation of economic models needs to be under construction now-after all, the main model
used at the Bank today is the culmination of nearly 30 years of research effort.
Conclusion
It is time for me to conclude. The renewal of our inflation-targeting agreement is good news.
Whether you remember the bad times or not, high, variable and unpredictable inflation is deadly
for confidence. It is a source of uncertainty that would be brutal in today's economic climate.
We will not let that happen. We have a record of more than 25 years as a successful
inflationtargeting central bank. This has helped businesses and individuals make financial decisions with
certainty and confidence. It has led to an environment that is conducive to sustained economic
growth.
The renewal of the inflation-targeting agreement sets us up to extend this track record of
success for another five years. But our framework is not set in stone. We will continue to
observe and learn, ask questions, and make sure our monetary policy is truly doing its best until
the next renewal in 2021. We will be looking for new ways to engage with Canadians in a
discussion about our framework, and would very much like to hear your ideas as we continue to
promote the economic well-being of Canadians.