Mark Carney: Renewing Canada's monetary policy framework
Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the
Financial Stability Board, to the Board of Trade of Metropolitan Montreal, Montreal, Quebec,
23 November 2011.
* * *
Over the past twenty years, Canadians have enjoyed a more stable and prosperous
economic environment. Even during the recent crisis, the Canadian economy proved more
resilient and recovered faster than our advanced-economy peers. The strength and relative
stability of our economy have been due, in part, to Canada's inflation-targeting regime, which
was first adopted in 1991. Earlier this month, the Government of Canada and the Bank of
Canada jointly announced the renewal of the target for five more years - re-affirming its
important role in enhancing the well-being of Canadians.
In my remarks today, I will discuss what went into this decision, while addressing three
important issues that the crisis brought into sharp relief. I will conclude by providing a brief
summary of how we apply this framework to today's circumstances.
Canada's monetary policy regime has proved its worth in both turbulent and tranquil
times
The effectiveness of Canada's inflation-targeting regime is well established. Since its
adoption, inflation has averaged 2 per cent, as measured by the consumer price index (CPI),
and its standard deviation has fallen by roughly two-thirds, compared with the 1970s and
1980s. Greater price stability has allowed Canadians and their businesses to manage their
finances with greater confidence. Interest rates have also been lower in both nominal and
real terms across a range of maturities. As a consequence of these developments, low,
stable and predictable inflation has encouraged more solid economic growth and lower and
less-variable unemployment.
The global economic and financial crisis of 2008-09 delivered the largest shock in decades,
putting the regime to an unprecedented test.
It passed.
The experience re-affirmed the strength of Canada's monetary policy framework, including
the value of the regime's inherent flexibility. Nonetheless, the Bank has sought to draw the
appropriate lessons from the debacle, particularly from the experiences of others for whom
price stability proved insufficient to prevent economic and financial disaster.
Our work has provided important insights into the management of our regime, as well as
potential lessons for other countries where trying circumstances have raised questions
regarding their monetary policy frameworks.
What is the optimal level of inflation?
There is an ongoing debate regarding the "right number" for the inflation target. We have
been targeting 2 per cent total CPI inflation, in recognition of the benefits of a slightly positive
inflation rate in facilitating economic adjustments, and of the potential operational challenges
associated with a lower target rate.1
Targeting an inflation rate lower than 2 per cent is intuitively appealing, since achieving the
target still causes the price level to double roughly every 35 years, which may contribute to
money illusion and more generally complicate inter-temporal decision-making. A lower
inflation target could also further reduce the costly distortions associated with inflation, such
as those stemming from difficulties in distinguishing between absolute and relative price
changes, the cost of infrequent price and wage adjustments, and the disincentives to hold
money. The Bank's research has generally found that the further benefits from reducing
these distortions imply an optimal rate of inflation closer to, or even slightly below, zero.
In a perfect world, we would pursue those gains through a lower inflation target. But we do
not live in a perfect world. Even the models that we employ to quantify the additional benefits
of a lower inflation target - models that aspire to an economist's utopia - disagree on how
material those benefits would be. Moreover, these models have typically abstracted from the
very real-world costs and risks associated with very low rates of inflation, the most important
of which is the risk associated with the zero lower bound (ZLB) on interest rates. At this level,
conventional monetary policy can no longer be used to stimulate the economy - a risk that
was brought into stark relief during the recent crisis.
The lower the inflation target, the lower the "equilibrium" nominal policy interest rate will be,
and thus the greater the likelihood that shocks will push interest rates to the ZLB during
"normal" times. Research at the Bank and elsewhere suggests that encounters with the ZLB
should be quite rare with a 2 per cent inflation target, but may be more than four times more
likely with a 1 per cent target and at least 16 times more likely with a zero per cent target.
Indeed, with a target below 2 per cent, it is likely that the ZLB will be encountered through the
ordinary course of the business cycle.
The costs of hitting the ZLB depend on the effectiveness, reliability and costs of available
unconventional policy instruments. While these unconventional tools - conditional
commitments, quantitative easing and credit easing - have provided additional stimulus, the
magnitudes of the benefits and of the costs associated with their use will only be known over
time. These costs could include financial market distortions, difficulties in unwinding large
holdings of securities, and in the extreme, potential compromises to the political
independence and credibility of the central bank.
With these risks now better appreciated, some have suggested that central banks ought to
target an inflation rate higher than 2 per cent. There are essentially two arguments. First, a
higher inflation target might reduce the frequency and severity of encounters with the ZLB.2
Second, a higher inflation target may be a way out from the burden of excessive debt in
those countries struggling with deleveraging.3
To the Bank of Canada, these are siren calls. Moving opportunistically to a higher inflation
target would risk de-anchoring inflation expectations and destroying the hard-won gains that
have come from the entrenchment of price stability in these economies. This is especially
risky if a very sudden and large inflation "surprise" is needed, as might be the case given the
relatively short duration of government debt portfolios in many of these countries. Moreover,
if inflation is both higher and more uncertain, a higher inflation risk premium might result,
prompting an increase in real rates that would exacerbate unfavourable debt dynamics.
Could targeting the price level be superior?
So in our view, moving to a higher inflation target would be risky. However, for foreign
countries with high levels of indebtedness and that are already at the ZLB, there might be
other mechanisms to achieve higher nominal price paths, while maintaining long-term
inflation expectations.
The Bank's research suggests that targeting a path for the level of prices might work. In
contrast to an inflation-targeting regime where bygones are bygones, under price-level
targeting (PLT), monetary policy would seek to make up for past deviations in order to
restore the price level to a predetermined path. For example, following a period of
belowtarget inflation, policy would seek a period of above-target inflation in order to ensure that
average inflation corresponds to targeted inflation (the desired rate of change in the price
level) over time. The more the price level were to undershoot the target, the more the central
bank would need to stimulate the economy to make up the undershoot, and the more
inflation expectations would thus be expected to rise and real interest rates to fall, supporting
spending and prices. This "automatic" provision of added stimulus could be particularly useful
when conventional monetary policy is exhausted at the ZLB, while the rise in near-term
inflation expectations would be self-limiting by design, unwinding as the price level
approached the desired path.
PLT may merit consideration as a temporary unconventional policy tool in countries faced
with extraordinary circumstances, notably those with policy at the ZLB and with a heavy
burden of debt.4 However, it is not clear that it would help much under the current
circumstances faced by the crisis economies. This is because the trend in the price level in
these countries since the onset of the global crisis has not, in fact, been all that weak.5 So
while PLT may help combat future disinflationary pressures in these countries, it is unlikely to
be effective in providing additional stimulus now.
Accordingly, some have proposed a related framework that could better harness the power
of expectations in getting these economies back on track right now - nominal GDP level
targeting. In this case, the central bank would seek to make up for the undershoot in the
trend in the value of national output.6 That undershoot has been dramatic, reaching 10 per
cent in the United States and 11 per cent in the United Kingdom - or nearly 2 trillion dollars
combined - relative to the level that would have been attained with trend growth.7 Those
gaps are set to widen even further ahead, with real growth projected to remain slow and the
inflation rate to fall. Committing to restore the level of nominal GDP to its pre-crisis trend
could lend the powerful boost to expectations needed to reduce real debt burdens and more
generally provide added stimulus to the economy through lower real interest rates.
There are, without question, risks to this approach. For PLT or nominal GDP level targeting
to be effective, the expectations channel has to work in practice the way it does in theory.
This requires that people be forward-looking, fully conversant with the implications of the
4
See C. Evans, "Monetary Policy in a Low-Inflation Environment: Developing a State-Contingent Price-Level
Target", Remarks delivered to the Federal Reserve Bank of Boston's 55th Economic Conference, Boston,
Mass: 16 October 2010.
5
In the third quarter, the level of the headline and core PCE price indexes in the United States stood 0.6 per
cent and 1.3 per cent respectively below the level that would have been attained with 2 per cent inflation since
the onset of the recession in the fourth quarter of 2007. The level of the headline CPI in the United Kingdom in
the third quarter stood 5.5 per cent above the level that would have been attained had inflation met the United
Kingdom's 2 per cent target since the onset of the recession in the first quarter of 2008.
6
See J. Hatzius and S. Stehn. "The Case for a Nominal GDP Level Target," US Economics Analyst, Goldman
Sachs Global ECS Research, Issue No: 11/41, 2011, and C. Romer, "Dear Ben: It's Time for Your Volker
Moment," The New York Times, 29 October 2011.
7
Assuming nominal GDP had grown at a 41⁄2 per cent annual rate in the United States and United Kingdom
from the level prevailing just prior to the onset of recession in these countries.
regime and trust policy-makers to live up to their commitment. As Bank research has shown,
if these conditions do not fully hold, these approaches could in fact prove destabilizing to the
economy and damaging to the central bank's credibility.8
Moreover, there are reasons why central banks have preferred to support employment and
output by targeting price stability, rather than more directly through an approach like nominal
GDP targeting. Central banks can neither determine the appropriate path for these real
variables nor control them over the long run, and pretending they can could have negative
consequences for economic stability and central bank credibility.
Indeed, one of the major insights over the past three decades of monetary policy practice
has been that targeting employment can create an incentive for surprise inflation, which in
turn leads to higher unemployment. The best contribution monetary policy can make to
sustainable job creation is low, stable and predictable inflation.
The Bank found that the potential benefits of adopting PLT are less valuable under ordinary
circumstances, relative to the current inflation-targeting regime. But the risks that the regime
might not be well understood or fully credible look no less daunting. Accordingly, the Bank
could not comfortably endorse the adoption of a PLT regime as Canada's monetary policy
framework. As is the case with unconventional monetary policy tools, however, the
experience of others may provide valuable insights for Canada in the future.
How to address financial imbalances?
The global economic and financial crisis has made it clear that a central bank pursuing price
stability without due regard for financial stability risks achieving neither. Even though Canada
did not experience a home-grown financial crisis, it is necessary for the Bank to understand
better the lessons painfully learned elsewhere.
As we have all been reminded at great cost, low, stable and predictable inflation and low
variability in activity can breed complacency among financial market participants, as
risktaking adapts to the perceived new equilibrium. Indeed, risk appears to be at its greatest
when measures of it are at their lowest. The tendency to overreach is particularly marked if
there is a perceived certainty about the stability of low interest rates. In short, complacency
can lead to extremes and, ultimately, crisis.
The first line of defence against a buildup of financial imbalances is responsible behaviour by
individuals and institutions. The more people recognize that they will bear the consequences
of their actions, the fewer the problems that will arise.
Next comes effective "microprudential" regulation and supervision. Canada has a strong
track record in this area, and our experience is being reflected in major international reforms
of regulatory and supervisory frameworks for banks.
This approach is being enhanced by the adoption of a system-wide perspective. The
Government of Canada has already made three timely and prudent adjustments to the terms
of mortgage finance. Additional measures, such as the counter-cyclical capital buffer and
through the cycle margining, are under development.
These defences will go a long way to mitigate the risk of financial excesses, but in some
cases, monetary policy may still have to take financial stability considerations into account.
This is most obviously the case when financial imbalances affect the near-term outlook for
output and inflation.
In some exceptional circumstances where imbalances pose an economy-wide threat and/or
where the imbalances themselves are being encouraged by a low interest rate environment,
monetary policy might itself be the appropriate tool to support financial stability. Monetary
policy has a broad influence on financial markets and on the leverage of financial institutions
that cannot easily be avoided. This "bluntness" makes monetary policy an inappropriate tool
to deal with imbalances that matter only to a specific sector, but a potentially valuable tool in
addressing imbalances that may eventually have economy-wide implications. Furthermore, a
general understanding that monetary policy will be used to counteract pre-emptively the
buildup of such imbalances is likely to enhance the stabilizing impact of this approach.
But this last point should not be overstated. The paramount goal of monetary policy in
Canada has been, and remains, price stability. The primary tools to deal with financial
stability are micro- and macroprudential regulation and supervision. Macroprudential tools
are not a substitute for monetary policy in controlling inflation, and monetary policy cannot
substitute for proper micro- and macroprudential supervision and regulation in maintaining
financial stability.
Confirming Canada's flexible inflation-targeting regime
Armed with these insights, the Bank and the Government have renewed the
inflationtargeting regime that has served Canada so well over the past two decades. The core
elements of the regime remain unchanged. The Bank will continue to conduct monetary
policy aimed at keeping inflation, as measured by the total consumer price index (CPI), at
2 per cent, with a control range of 1 to 3 per cent around this target.
The inflation target is symmetric, which means that the Bank is equally concerned about
inflation rising above or falling below the 2 per cent target. The Bank continues to use core
inflation as an operational guide for its monetary policy because it is an effective indicator of
the underlying trend in CPI inflation. Core inflation, along with other measures of inflationary
pressures, is monitored to help achieve the target for total CPI inflation; it is not a
replacement for the latter.
A flexible exchange rate is also a core element of Canada's monetary policy framework. A
floating Canadian dollar plays a key role in the transmission of monetary policy and allows
the Bank to pursue an independent monetary policy. It also helps to absorb shocks to the
economy.
The inflation-targeting framework has always been flexible. Typically, the Bank seeks to
return inflation to target over a horizon of six to eight quarters. However, over the past twenty
years, there has been considerable variation in the horizon, in response to varying
circumstances and economic shocks. This flexibility is required because, when taking
monetary policy actions to stabilize inflation at target, the Bank must also manage the
volatility that these actions may induce in the economy. These trade-offs will differ depending
on the nature and persistence of the shocks buffeting the economy.
There are limits to this flexibility. The Bank's scope to exercise it is founded on the credibility
built up through its demonstrated success in achieving the inflation target. This reinforces the
importance of continuing the Bank's relentless focus on achieving the 2 per cent inflation
target over time.
Conclusion
Let me conclude with a quick illustration of how we are applying the framework under current
circumstances. As recently as July, markets were expecting the near-term withdrawal of
monetary policy stimulus in Canada. At that point, the policy interest rate had remained near
historic lows for the better part of a year, even after Canada had recovered both all of the
jobs and all of the output lost during the recession. This degree of stimulus was in part
necessitated by the considerable external headwinds facing the Canadian economy,
including weak U.S. activity and the persistent strength of the Canadian dollar. Since then,
the Canadian economy has been hit by major shocks. The global economic outlook has
weakened considerably and financial market volatility has increased, owing in particular to
the ongoing European sovereign debt crisis. European authorities have announced important
plans to provide time to refound their monetary union, but acute strains persist. At this point,
the crisis appears barely contained.
In Canada, total CPI inflation is near the top of the target range, and preliminary evidence
suggests that economic growth in the second half of the year will be slightly stronger than the
Bank had projected in the October Monetary Policy Report. However, as outlined in the
October Report, a weaker external outlook is expected to dampen growth in Canada through
financial, confidence and trade channels. Domestic demand is expected to remain the
primary driver of growth in Canada, but these shocks from abroad imply more subdued
growth in household expenditures and less vigorous growth in business investment. As a
result, the Bank continues to expect excess supply in the economy to persist well into 2013.
This, along with the reversal of earlier sharp increases in food and energy prices, is expected
to push total CPI inflation toward the bottom of the target range by the middle of next year.
In this environment, the Bank judges it appropriate to maintain the considerable monetary
stimulus in place. This stimulus has been further enhanced by the sharp fall in global
riskfree yields, which is providing further support to the Canadian economy through our
wellfunctioning financial system. The Bank will continue to monitor carefully economic and
financial developments in the Canadian and global economies, together with the evolution of
risks, and set monetary policy consistent with achieving the 2 per cent inflation target over
the medium term.
In a perfect world, there would be no further shocks, and those that have hit us would have
precisely the effects that we anticipate. Then again, in a perfect world, these shocks wouldn't
have happened in the first place. We make monetary policy in the real world, where shocks
are a fact of life. That is why the Bank responds with a flexible approach, taking decisions
guided by considered analysis and informed judgment rather than mechanical rules. It is our
job to anticipate potential shocks, analyse their impact on economic activity and inflation in
Canada, and set monetary policy consistent with achieving the 2 per cent inflation target over
time. This ultimately remains the best contribution that monetary policy can make to the
economic well-being of Canadians.