Remarks by Paul Beaudry
Deputy Governor
Alberta School of Business
February 16, 2023
Edmonton, Alberta
No two ways about it: Why the Bank is
committed to getting back to 2%
Introduction
Good afternoon. Bonjour tout le monde. It is a pleasure to be here in Edmonton.
We have all been going through challenging economic times recently. Almost
exactly three years ago, the COVID-19 pandemic hit Canada, suddenly shutting
down large parts of our economy. This upended our lives and livelihoods and
created a huge disruption in financial markets. Fiscal and public health policies
led the charge in tackling these dangers. The Bank of Canada played a key
supporting role by reducing its policy interest rate to near zero and unblocking a
financial system that was clogging up.
The recession caused by the pandemic was unprecedented. Canada lost over
3 million jobs, and the unemployment rate rose to 14% in May 2020. And, as
many here likely recall, oil prices even briefly turned negative.
Fortunately, though, when the economy reopened after the mass closures, the
rebound was also unprecedented. By the end of 2021, Canadian employment
was 250,000 jobs above its pre-pandemic level, and the unemployment rate had
fallen to 6%. But a storm was brewing. Supply chain bottlenecks, higher energy
prices and a massive shift in global consumption patterns came together to spur
inflationary pressures. The disruptions caused by the war in Ukraine only added
fuel to this fire.
In response, the Bank raised its policy interest rate to 4.5% in a series of rapid
hikes. These interest rate increases are working. Over the past few months,
inflation has started to come down. Recently it reached 6.3%, down from a peak
of 8.1% last summer. This is a welcome improvement. But inflation is still too
the Bank's
high and far from 2% target. At its current level, it continues to cause
hardships for Canadians, especially the most vulnerable among us.
While Canada may have turned the corner on inflation, we know that it will take
Bank's like
time to get back to the inflation target. So, I'd to take this opportunity
- 2 -
to talk about the importance of staying the course in the fight against inflation,
despite the short-term pain that high interest rates can cause.
First, I want to talk about the benefits of returning to the 2% inflation target.
I'll
Specifically, emphasize how inflation dynamics tend to be self-stabilizing when
I'll
inflation is near the target and how that helps the economy function better.
also stress how low, stable inflation leads to better employment outcomes.
like Here I'll
Second, I'd to highlight the dangers of straying from the 2% target.
talk about how the stabilizing forces I just mentioned can turn into de-stabilizers.
The high and volatile inflation that can result is troublesome for many reasons,
including the fact that it makes the price system less informative. This can
undermine efficiency and weaken the competitive forces that help the economy
achieve its full potential.
Finally, I want to place the current Canadian situation in a global context.
Although most of our trading partners are also experiencing high inflation, their
paths back to their own inflation targets may end up being different than ours.
Should this be a concern? We'll dive into that question.
The benefits of being near the 2% target
The Bank is fully committed to returning inflation to the 2% target. For three
decades, this target has served Canadians well. And since it represents a sweet
of the Bank's
spot on the inflation spectrum, it remains the centrepiece
inflationtargeting framework. Keeping inflation stable and predictable at that low level is
the best contribution monetary policy can make to the economic and financial
well-being of Canadians.1
To better understand the value of a 2% inflation target, we first need to delve into
firms'
some of the forces that influence price-setting behaviour. These are
illustrated in Figure 1, which will serve as a roadmap for much of my talk today.
Inflation dynamics are driven largely by the cost pressures that firms face. These
pressures can come from both domestic and international sources.
Domestic cost pressures tend to appear when the economy is in excess
firms face levels of demand beyond what they're able to
demand-that is, when
supply on a sustainable basis. As firms strain to meet that excess demand, they
not only increase their prices but also bid up wages and the prices of other inputs
as they compete with other firms for workers and materials. And since the goods
produced by one firm are often inputs for other firms, this can lead to a second
round of effects that further broaden and amplify domestic cost pressures.
1
In this speech, I mainly compare 2% inflation with higher rates of inflation. However, the Bank
has also studied the costs and benefits of lower rates of inflation. A key takeaway from that work
is that the 2% inflation target provides a reasonable buffer against the effective lower bound
(ELB) on nominal interest rates. In contrast, lower rates of inflation entail a higher risk of ELB
episodes. See, among others, Bank of Canada, Renewal of the Inflation-Control Target:
Background Information-November 2011 (2011) and Bank of Canada, Renewal of the
InflationControl Target: Background Information-October 2016 (2016).
- 3 -
Of course, cost pressures can also come from international developments-
things like disruptions to global supply chains and increases in the price of
commodities such as oil.
Figure 1 shows how these pressures impact the price-setting decisions of firms.
Figure 1: Key forces governing firms' price-setting behaviour
Domestic cost pressures International cost pressures
(largely via excess demand) (e.g., global value chain disruptions, oil prices)
Weak Strong
pass-through pass-through
Firms' price-setting decisions
Inflation expectations
Strong Weak
anchoring anchoring
Inflation target Inflation outcomes
Low inflation environment High inflation environment
But another key force affecting inflation is what firms expect to happen. These
expectations matter because firms know that customers will ultimately judge
firms'
prices in relative terms-that is, relative to the prices of other goods and
firm's pricing decisions
services trading in the broader economy. A are therefore
based partly on what the firm thinks its competitors will do and where it believes
overall inflation is headed.
Now here's my main
point. The key forces affecting inflation-that is, cost
pressures and expectations-tend to behave differently based on whether
inflation is high or whether the economy is operating close to a well-established
and low inflation target. These differences are illustrated by the blue and red
arrows in Figure 1.
First, let's
focus on cost pressures. In high inflation environments, firms tend to
adjust prices more frequently-otherwise, their prices would quickly fall out of
- 4 -
step with their costs and the prices set by other firms.2 This makes it relatively
4
easy for firms to quickly pass on cost changes to their customers.3,
In contrast, firms can make do with less frequent price adjustments when inflation
is low. Rather than being passed on to customers, much of the day-to-day
firms' firms'
volatility in costs tends to be absorbed into profit margins when
firms' costs and
inflation is low. This lessens the likelihood of feedback into other
prices. It also helps explain why low inflation tends to go hand in hand with less
volatile inflation. We can see this pattern within countries over time (Chart 1) and
across countries (Chart 2).
Much as with cost pressures, a self-stabilizing mechanism can take hold around
expectations when inflation is close to target. When a central bank has built up a
credible track record of stabilizing the economy around a low inflation target,
firms tend not to pay much attention to inflation. Rather than basing their
expectations on recent rates of inflation or on short-term shocks hitting the
economy, they're more inclined to settle on a simple rule of thumb that says
inflation should continue to evolve in line with the central bank's target.
2
For a formal model in which firms find it optimal to increase the frequency of their price
adjustments when trend inflation is high, see, for example, M. Dotsey, R. G. King and A. L.
Wolman, "State-Dependent Pricing and the General Equilibrium Dynamics of Money and Output,"
Quarterly Journal of Economics 114, no. 2 (1999): 655-690.
3
firms' marginal costs in the
For example, in standard New Keynesian models, the weight on
Phillips curve governing inflation typically increases in a structural parameter representing the
frequency with which firms adjust their prices. See, for example, F. Smets and R. Wouters,
"Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic
Review 97, no. 3 (2007): 586-606.
4
For a complementary mechanism that also helps to make inflation more volatile when it's high,
see M. Harding, J. Lindé and M. Trabandt, "Understanding Post-COVID Inflation Dynamics,"
Bank of Canada Staff Working Paper No. 2022-50 (December 2022).
- 5 -
Chart 1: Strong positive relationship between the level and volatility of inflation
within countries over time
a. United States b. Canada
Percentage points
%
Percentage points
%
8 5 8 5
4 4
6 6
3 3
4 4
2 2
2 2
1 1
0 0
0 0
1960Q1 1970Q1 1980Q1 1990Q1 2000Q1 2010Q1 2020Q1
1960Q1 1970Q1 1980Q1 1990Q1 2000Q1 2010Q1 2020Q1
to to to to to to to
to to to to to to to
1969Q4 1979Q4 1989Q4 1999Q4 2009Q4 2019Q4 2022Q3 1969Q4 1979Q4 1989Q4 1999Q4 2009Q4 2019Q4 2022Q3
Average inflation (left scale)
Standard deviation of inflation (right scale)
Note: Averages and standard deviations have been computed from underlying annualized quarter-over-quarter inflation rates.
Sources: Organisation for Economic Co-operation and Development
via Federal Reserve Economic Data and Bank of Canada calculations Last observation: 2022Q3
Chart 2: Strong positive relationship between the level and volatility of
inflation across countries
Standard deviation of inflation
Decadal summary statistics
(percentage points)
12
10
8
6
4
2
0
0 5 10 15 20
Average inflation (%)
1980s 1990s 2000s 2010s
Note: The sample consists of 37 advanced and emerging economies, including most of the Organisation for Economic Co-operation and
Development. Averages and standard deviations have been computed from underlying monthly year-over-year percentage changes.
Observations for all countries are not available for all months. Observations involving extreme inflation outcomes have been excluded
(decadal average > 20%, decadal standard deviation > 10 percentage points). Dotted lines denote decade-specific lines of best fit. Each
dot represents a mapping between the standard deviation of inflation and average inflation, for a given country in a given decade.
Sources: Organisation for Economic Co-operation and Development
Last observation: December 2019
via Haver Analytics, and Bank of Canada calculations
- 6 -
As firms begin to rely on this rule of thumb, it becomes self-reinforcing. The
inflation outcomes that result from the price-setting decisions of firms start falling
line with the central bank's target,
in and this makes the rule of thumb even more
reliable going forward.
The rule of thumb therefore reduces feedback loops and helps ensure that any
straying from the inflation target is relatively small and short lived.
With these self-stabilizing mechanisms at work in the economy, monetary policy
can pursue its inflation target with a high degree of flexibility. In an environment
of low and stable inflation, the inflationary effects of shocks tend to be muted.
Monetary policy can therefore look past many of these shocks and respond to
others in a more measured way.
This flexibility allows monetary policy not only to keep inflation low and stable but
also to minimize the impacts of shocks on the labour market and the broader
economy. This is a key benefit of successful inflation targeting and an important
reason why the Bank is working so hard to get inflation back to 2%.
The pitfalls and dangers of not returning to target
For the better part of the last 30 years, Canada has benefited from the
selfstabilizing mechanisms I just described.5
being tested
But these mechanisms cannot be taken for granted. In fact, they're
by the series of large shocks that our economy has experienced over the past
18 months. The longer inflation stays significantly above target, the greater the
risk that these mechanisms could turn from stabilizers into de-stabilizers.6
For example, mounting evidence shows that over the past two years
passthrough from costs to prices has been stronger and more widespread than before
that's partly because firms tend to adjust
the pandemic.7 As I explained earlier,
5
In fact, many countries around the world have benefited from these self-stabilizing mechanisms.
Indeed, the harnessing of these mechanisms that occurs under credible inflation-targeting
frameworks was a key contributor to the Great Moderation era in advanced economies. See, for
example, D. Giannone, M. Lenza and L. Reichlin, "Explaining the Great Moderation: It Is Not the
Shocks," European Central Bank Working Paper No. 865 (February 2008) and references
therein.
6
For an in-depth analysis of this risk, see Bank for International Settlements, "Part II: Inflation: a
look under the hood," Annual Economic Report (June 2022).
7
the Bank of Canada's
For example, before the COVID-19 pandemic, results of Business
Outlook Survey often showed that a relatively small share of firms planned to increase their prices
in the short term, while at the same time, a relatively large share of firms expected their costs to
rise. This pattern is consistent with low pass-through of costs to prices. However, this pattern was
broken in 2021 and 2022 when, in multiple quarters, the share of firms expecting to increase their
prices was equal to or larger than the share expecting increases in costs. For details, see "Chart
9: Businesses expect growth in their input and output prices to slow," Business Outlook Survey-
Fourth Quarter of 2022 (January 2023). See also M. Amiti, S. Heise, F. Karahan and A. Sahin,
Liberty
"Pass-Through of Wages and Import Prices Has Increased in the Post-COVID Period,"
R. Asghar, J. Fudurich and J. Voll, "Firms' inflation
Street Economics (blog, August 23, 2022) and
- 7 -
prices and pass costs on to customers more frequently in high inflation
environments.
also seen
We've this past year how quickly inflation can go from being a topic
I've illustrated
few people think about to one that is top of mind for many. this in
Chart 3.8
Chart 3: Canadians' attention to inflation in high and low inflation
environments: suggestive evidence from threshold regressions
a. Google searches for "inflation" in Canada b. Newspaper articles mentioning
"inflation" in Canada
Normalized frequency
Share of total articles (%)
100 25
Estimated threshold = 3.3%
Estimated threshold = 3.4%
80 20
60 15
40 10
20 5
0 0
-2 0 2 4 6 8 -2 0 2 4 6 8
CPI inflation (year-over-year percentage change, %)
CPI inflation (year-over-year percentage change, %)
Estimated relationships below threshold
Estimated relationships above threshold
Data
Note: Thresholds and the relationships prevailing above and below them have been estimated using the regression methodology described
in O. Korenok, D. Munro and J. Chen, "Inflation and Attention Thresholds," working paper (September 2022). The samples begin in January
2004 for Google searches and January 2000 for newspaper mentions. Google search frequencies have been normalized to take a value of
100 at their maximum. The methodology for computing newspaper mentions is described in L. Chen and S. Houle, "Turning Words into
Numbers: Measuring News Media Coverage on Shortages," Bank of Canada Staff Discussion Paper (forthcoming). Each dot represents the
mapping between the number of Google searches for the word "inflation" (panel a) or share of total articles mentioning inflation (panel b)
and the level of CPI inflation, for a given month.
Sources: Cision, Google Trends, Statistics Canada via Haver Analytics,
and Bank of Canada calculations Last observation: December 2022
As more and more households and firms look backward and focus on recent high
inflation numbers, those numbers can start to displace the inflation target as a
focal point for peoples' expectations. If people start to base their expectations for
inflation on the high inflation numbers they've been seeing lately rather
than on
the 2% inflation target, high inflation will become more persistent, volatile and
self-perpetuating. Without a sufficiently strong policy response, a drift in
expectations and price-setting behaviour in Canada: Evidence from a business survey," Bank of
Canada Staff Analytical Note (forthcoming).
8
This chart updates and extends some work by academics outside the Bank that suggests the
people's attention to it can change significantly when inflation
relationship between inflation and
rises above a threshold level. See O. Korenok, D. Munro and J. Chen, "Inflation and Attention
Thresholds," working paper (September 2022).
- 8 -
the Bank's
expectations away from inflation target can open the door to inflation
remaining high and volatile for a long period of time.
As Canadians know all too well, high and volatile inflation makes it difficult for
everyone to plan how to spend and invest. For example, companies find it more
don't feel
difficult to make key decisions for growing their business when they
confident about what their costs will be in the years ahead. And financial planning
for households is also much more challenging.
But the negative effects don't stop there. Increased volatility in inflation can also
be costly because it scrambles the signals from prices and makes it hard to judge
whether a higher price represents a true change in costs or something else. This
makes it difficult for firms and investors to allocate resources to their best uses.9
It can also impact consumer behaviour in ways that make the economy less
efficient.
Let me break that last point down into steps.
Say inflation is stable, and for a particular good you notice a price increase that is
far out of line with the rate of inflation. This leads you to shop around because
you think you can find a better price elsewhere. However, when inflation
becomes high and volatile, many prices in the economy start moving up together.
Seeing a higher price may no longer prompt you to search for a better one
That's a
because you may believe that all other prices have also increased.
If people don't
problem because comparison shopping encourages competition.
believe they can find a better price by shopping around, firms have more leeway
to increase markups, leading to distortions that make the economy less efficient
and consumers worse off.10
If inflation stays above target for a significant amount of time, then high and
variable inflation will likely go hand in hand with a less efficient, more distorted
economy. Of course, an inefficient economy rife with distortions makes it hard to
grow overall output and employment in any kind of sustainable way.
Canadians have seen this situation play out before, particularly in the 1970s and
It's also consistent with
1980s. international data-we tend to see higher
unemployment in countries where inflation is more volatile (Chart 4).
can't
The takeaway then is clear. Even if inflation has declined lately, we take our
eyes off it too soon and let it remain significantly above target for too long.
9
Schiantarelli,
See, for example, P. Beaudry, M. Caglayan and F. "Monetary Instability, the
Predictability of Prices, and the Allocation of Investment: An Empirical Investigation Using U.K.
Panel Data," American Economic Review 91, no. 3 (June 2001): 648-662.
10
For a model-based demonstration of this mechanism in markets with sufficiently high search
costs, see R. Bénabou and R. Gertner, "Search with Learning from Prices: Does Increased
Inflationary Uncertainty Lead to Higher Markups?" Review of Economic Studies 60, no. 1
(January 1993): 69-93.
- 9 -
Chart 4: Positive cross-country relationship between unemployment and the
volatility of inflation
Decadal summary statistics
Average unemployment rate (%)
25
20
15
10
5
0
0 2 4 6 8
Standard deviation of inflation (percentage points)
1980s 1990s 2000s 2010s
Note: The sample consists of 37 advanced and emerging economies, including most of the countries in the Organisation for Economic
Co-operation and Development. Averages and standard deviations have been computed from underlying monthly observations, using
year-over-year percentage changes for inflation. Observations for all countries are not available for all months. Observations involving
extreme inflation outcomes have been excluded (decadal average > 20%, decadal standard deviation > 10 percentage points). Dotted
lines denote decade-specific lines of best fit. Each dot represents a mapping from the standard deviation of inflation to the average
unemployment rate, for a given country in a given decade.
Sources: Organisation for Economic Co-operation and Development
Last observation: December 2019
via Haver Analytics, and Bank of Canada calculations
Different paths back to normal
As we work our way back to our inflation target, we need to keep another factor
in mind too.
Although many countries have faced similar shocks over the past few years, their
as
experiences with high inflation have not been the same Canada's. Our paths
back to target might differ as well.
For a trading nation like Canada, what does this mean? How will the Canadian
economy adjust if our inflation path is different than, say, that of our main trading
partner, the United States?
The answer to this question requires us to discuss another key element of the
Bank's
inflation-targeting framework-Canada's flexible exchange rate.
Bank of Canada doesn't set the dollar's exchange rate. We let markets set
The
the dollar's
value according to the forces of supply and demand. Letting the
Canadian dollar float in this way gives the Bank the flexibility to chart a path
that's different
than the path our trading partners take. Rather than trying to
maintain a particular value for the dollar, the Bank can instead focus on setting
interest rates to return inflation to 2%.
Suppose we enter a period during which inflation is lower in Canada than it is in
one of our trading partners. Over time, this difference in inflation would create a
divergence in price levels between the two economies because the price of
goods in Canada would be rising more slowly than the price of goods in the other
country.
What happens next depends on exchange rates.
Without an exchange-rate response, our relatively lower prices would be good
That's because
news for Canadian competitiveness. the price of Canadian
products would fall for our trading partner, making Canadian goods more
appealing.
Over time, however, exchange rates often adjust-sometimes slowly-in ways
that offset this sort of divergence in price levels.
For example, you might be familiar with the Big Mac index compiled by The
Economist. As Chart 5 shows, G7 currencies have a moderate tendency to
adjust in ways that help enforce a sort of "law price" for McDonald's
of one Big
Macs. If the local price of a Big Mac-converted to US dollars at the prevailing
exchange rate-is significantly higher than the price of a Big Mac in the United
States, that gap tends to close through a nominal depreciation of the local
currency over the subsequent years.
Chart 5: Correlating medium-run exchange rate movements in the G7 with
deviations from the law of one price (as measured by The Economist's Big
Mac index)
Nominal appreciation against the US dollar over next five years (%)
60
50
40
30
20
10
0
-10
-20
-30
-40
-30 -20 -10 0 10 20 30 40 50
Degree of overvaluation predicted by the Big Mac index (%)
Note: The sample begins in 2000 and consists of data from Canada, France, Germany,
Italy, Japan and the United Kingdom. The dashed line is a line of best fit. Last observations: Big Mac index, January 1, 2014;
Sources: The Economist, Haver Analytics and Bank of Canada calculations exchange rates, January 1, 2019
there's a lot of
Of course, noise in this relationship, and exchange-rate
movements are always difficult to predict. But, generally, either of two outcomes
could emerge if Canada manages to return inflation to target sooner than our
trading partners do. Neither outcome is bad. In fact, each has its own set of
advantages.
On the one hand, as I mentioned, lower Canadian prices could improve our
don't
competitiveness if exchange rates adjust. Canadian exports would
therefore be more attractive to foreign buyers, and that would be good for growth
and job creation.
On the other hand, if the exchange rate does adjust when prices diverge, then
returning to target sooner than our partners do could lead to an appreciation of
the Canadian dollar over time, all other things being equal. That would undo the
competitive advantages related to exports, but it would give Canadians here at
home more purchasing power for foreign goods.
we shouldn't be too concerned
The bottom line is that if Canada follows a slightly
different path to normalization than our counterparts. What matters most is
getting all the way there.
Conclusion
High inflation has been painful for Canadians. And so have higher interest rates.
the Bank's
Getting back to target rate of inflation will bring many benefits and
help us sidestep many risks. It will allow the economy to work more efficiently
and avoid the distortions that come with high and volatile inflation. This is good
the economy as a whole. That's why
for households, workers, businesses and
the Bank is committed to getting there. Being resolute in pursuit of this goal
the Bank's people's awareness of
matters. In fact, resolve-and it-will help
economy
Canada's reach the target faster and with less pain than if the Bank is
half-hearted and lets up too soon.
When it comes to inflation, stability begets stability and volatility produces
few years, we've had too much of
volatility. We can all agree that, over the past
the latter in our lives and not nearly enough of the former. Returning to the 2%
inflation target will bring back the stability Canada has known for the past
30 years, to the benefit of all Canadians.