TOWARD 2021: REVIEWING THE MONETARY POLICY FRAMEWORK
Remarks by Lawrence Schembri
Deputy Governor of the Bank of Canada
Manitoba Association for Business Economists
Winnipeg, Manitoba
February 15, 2018
Anchoring Expectations:
Canada's Approach to Price Stability
Introduction
Thank you for the invitation to speak to you today here in the hometown of
James Coyne.
Mr. Coyne, who died in 2012, was the governor of the Bank of Canada from 1955
to 1961. As governor, he stressed that price stability should be the primary
function of monetary policy.
That principle-price stability-is now the cornerstone of monetary policy
frameworks around the world. In practice, it is achieved by maintaining inflation at
a low, stable and predictable level.
Our mandate at the Bank of Canada's is to "promote the economic and financial
welfare of Canada." And, like former Governor Coyne, we believe that inflation
control is the main contribution monetary policy can make to achieving that goal.
Our current monetary policy framework consists of an explicit inflation target and
a flexible exchange rate. It was established in an agreement with the federal
government in 1991 and, since 2001, has been renewed every five years.
With this framework, we have anchored inflation expectations, achieved low and
stable inflation, and promoted sustained employment and economic growth.
Three main factors have contributed to the framework's credibility and success.
First, we have a clear, simple and well-understood inflation target, whose focal
point is 2 per cent. Second, the framework has political legitimacy, is coherent
with other public policies and is implemented with effective tools. And third, we
have a formal review process for continually improving the framework that is
widely admired by many of our peers and was cited as one of the factors that
earned us the Central Bank of the Year Award we received recently.
My speech today is the first in a series that my colleagues and I will be delivering
over the next four years as we embark on our review of the framework leading up
to the 2021 renewal of the inflation target.
I'll start with some background on our experience-and that of many other
central banks-with inflation in the 1970s and 1980s and on the lessons we
learned trying to control it. I'll discuss how and why the Bank adopted an inflation
target for its monetary policy. I'll review the impact of the policy on inflation, why it
works so well, and the unique and innovative process we follow to ensure that it
remains effective. Finally, I'll conclude with a discussion of important economic
developments affecting economies worldwide. Strengthening the framework to
manage the potential risks these developments pose to the Canadian economy
is the key objective of our research over the next four years.
The search for an anchor
Monetary policy needs a nominal anchor or a fixed point of reference to help tie
down the expectations people have about inflation. During the 1960s, that anchor
in most countries was a pegged nominal exchange rate that linked the value of
domestic currencies to the US dollar.1 This exchange rate arrangement, known
as the Bretton Woods system, collapsed in the early 1970s, largely because of
unsustainable inflationary pressure in the United States. Without an anchor for
monetary policy, inflation and inflation expectations rose rapidly, exacerbated by
large oil price shocks. In some years, inflation hit double-digit levels in Canada
and in other advanced economies.
Economist Milton Friedman's great insight into inflation is that it is always and
everywhere a monetary phenomenon, which led him to claim that low inflation
could be achieved by controlling the growth rate of money. He also emphasized
that inflation expectations are influenced by monetary policy and that they
eventually adjust to actual inflation. For this reason, he argued, there is no
longrun trade-off between inflation and output.2 Thus, central banks should focus on
controlling inflation.
In 1975, the Bank adopted a money supply target. But, by 1982, we were forced
to abandon it-or, rather, it abandoned us, as former Governor Gerald Bouey
once quipped-after it became clear that financial innovations had weakened the
Bank's ability to control the money supply and overall spending with its policy
interest rate.3 Unfortunately, by then inflation and inflation expectations had risen
and the expectations had become so entrenched that inflation declined only
when the Bank of Canada and most other major central banks boldly increased
interest rates in the early 1980s. It worked, but at the cost of a severe global
recession.
After this disinflation, the Bank renewed its search for a viable nominal anchor
and considered various options.4 We tried to identify one that would be effective,
straightforward to operationalize and easy to communicate, and that the public
would trust.
In the late 1980s, then-Governor John Crow delivered several speeches in which
he laid out an argument in favour of price stability itself as a long-run goal for
monetary policy.5 The inflation rate was then running at roughly 5 per cent. No
one knew with certainty what rate best represented price stability. And economic
theory was not yet developed enough to confidently predict the outcome of such
a policy, if implemented.
Still, the idea of using the policy rate to directly target the rate of inflation held
promise. At the time, only one other country in the world had attempted such a
policy approach: New Zealand adopted inflation targeting in 1990. Canada
became the second the following year when the Bank and the Department of
Finance announced an agreement on a monetary policy framework that set a
path for reducing inflation.6 The agreement gave the Bank operational
independence to use its statutory tools to achieve the inflation target, while at the
same time acknowledging that "a range of public policies, besides monetary
policy, can make a significant contribution" to controlling inflation.7
3
The measure of the money supply targeted was M1, which includes its most liquid components:
coins, cash and chequing accounts. The innovations that made it difficult to target were in both
non-personal and personal banking. The years leading up to and following its abandonment in
1982 witnessed an exhaustive search for alternative, broader aggregates of the money supply
that could be targeted instead, although a suitable replacement was not ultimately found. For an
account of this search, see F. Caramazza, D. Hostland and S. Poloz, "The Demand for Money
Journal of Policy Modeling
and the Monetary Policy Process in Canada," 12, no. 2 (Summer
1990): 387-426.
4
These options included different monetary aggregates, along with nominal spending, the
exchange rate and the price level. See P. Duguay and D. Longworth, "Macroeconomic Models
Economic Modelling
and Policy Making at the Bank of Canada," 15, no. 3 (July 1, 1998): 357-75.
5
J. Crow, "The Work of Canadian Monetary Policy," The Eric John Hanson Memorial Lecture Series
II (Winter 1988), Department of Economics, University of Alberta, Edmonton, January 18, 1988.
6
The agreement established a path for a progressive reduction in the rate of inflation to 3 per
cent by the end of 1992, 2 1/2 per cent by the middle of 1994 and 2 per cent by the end of 1995.
The agreement provided no specific target for the post-1995 period, although it was understood
that the experience of the first four years would inform the selection of the target. The target has
remained at 2 per cent since then and is tracked by Statistics Canada's measure of total CPI
inflation.
7
The Bank of Canada Act gives the Minister of Finance the ability to issue a binding directive to
the Governor if the two encounter irreconcilable differences concerning monetary policy. This
power has never been exercised. Its use would entail significant political costs: the directive must
be made public and would likely trigger the Governor's resignation.
Since 1995, our inflation-control target has been 2 per cent, the midpoint of a 1 to
3 per cent range. Central banks in many other countries-37 in total-have now
also adopted an inflation target and most, especially in advanced economies,
have chosen 2 per cent as their target. Experience suggests that 2 per cent is
sufficiently low that it does not materially distort economic decision making and
behaviour, but still leaves the central bank adequate room to lower its policy rate
in response to a significant adverse shock to the economy. Because a 2 per cent
target balances these offsetting considerations, it is symmetric. In other words,
we care equally about deviations above and below 2 per cent. The 1 to 3 per
cent range reflects normal variations in consumer price index (CPI) inflation,
since it is subject to a wide variety of temporary shocks. These ongoing shocks
make it impossible to hit the 2 per cent target consistently.
We aim to achieve the target by adjusting our policy rate, which directly
influences interest rates for household and corporate borrowing. Doing so helps
align demand for domestically produced goods and services with the economy's
capacity to supply them. If aggregate demand is expected to exceed or fall short
of the economy's potential output, we typically raise or lower the policy interest
rate to close the gap and keep inflation on target.
As I mentioned earlier, the other central pillar of our monetary policy framework is
a flexible, market-determined exchange rate. It serves two important functions: it
allows Canada to have an independent inflation target; and it helps the economy
adjust to external shocks, most notably, movements in commodity prices.
The outcome
It's not often that a policy performs better than expected. Our inflation-control
target did just that, and continues to do so.
Over the past 27 years, we have reduced inflation as measured by the CPI and
maintained it at a level close to our 2 per cent target, with no persistent episodes
outside our control range (Chart 1).8 Because inflation has been so close to the
2 per cent target, it has served as an anchoring and coordinating mechanism,
allowing Canadians to make better economic decisions and achieve better
economic outcomes. In addition, there has been much less volatility in interest
rates and output growth.
We have learned some key lessons from this experience.
First, the clarity and simplicity of the 2 per cent target has facilitated its
communication and broad acceptance, and that has helped enhance the target's
credibility.
- 5 -
Second, as inflation expectations have become firmly anchored at the 2 per cent
target, the effectiveness of the policy has increased (Chart 2).9 For example,
during the global financial crisis of 2007-08, the Bank was able to aggressively
reduce its policy rate and provide substantial monetary stimulus because inflation
expectations were so well anchored. As a consequence, a reduction in the policy
rate translated directly into a similar reduction in the real interest rate, which is
necessary for stimulating demand.10
Third, the more successful we are at hitting the target, the more credible the
policy is and the more confident Canadians are that inflation will remain on target
(Figure 1).11 This self-reinforcing feedback loop has been instrumental in our
ability to keep inflation on target.
Chart 1: Since 1991, inflation has remained mostly within the control range
Consumer price index inflation, year-over-year percentage change, monthly data
%
14
12
10
8
6
4
2
0
-2
1975 1980 1985 1990 1995 2000 2005 2010 2015
Inflation-control range CPI inflation Inflation target Agreement dates
Last observation: December 2017
Sources: Statistics Canada and Bank of Canada
We also recognize that the credibility and success of our inflation-targeting
regime depends critically on the coherence of the macroeconomic and financial
policy framework in Canada. For monetary policy to be effective, it must be
9
Champagne and Sekkel find that monetary policy shocks have a slightly stronger impact on
output after the adoption of an inflation-targeting regime. See J. Champagne and R. Sekkel,
Changes in Monetary Regimes and the Identification of Monetary Policy Shocks: Narrative
Evidence from Canada, Staff Working Paper No. 2017-39, Bank of Canada, 2017.
10
This was not always the case. In the early 1990s, when expectations were less well anchored,
the Bank found it difficult to reduce the policy rate because the exchange rate would depreciate
sharply.
11
For recent evidence on the impact of the inflation target on inflation expectations in Canada,
see P. Beaudry and F. Ruge-Murcia, "Canadian Inflation Targeting," Canadian Journal of
Economics 50, no. 5 (December 2017): 1556-1572; and J. Yetman, "The Evolution of Inflation
Expectations in Canada and the US," Canadian Journal of Economics 50, no. 3 (August 2017):
711-37.
complemented by sustainable fiscal policy, as well as strong financial regulation
and supervision that promote financial stability.
Because inflation targeting has worked so well, it is easy to lose perspective. We
now discuss inflation in decimal points rather than the percentage points we were
worried about in the 1980s, when inflation was running, in some years, above
10 per cent. At the same time, we must also understand that when inflation is
persistently away from the target, as it has been in recent years, we run the risk
that inflation expectations will drift away from 2 per cent.
Chart 2: Inflation expectations have become well anchored in Canada
Medium-term inflation expectations, year-over-year percentage change, quarterly data
%
3.0
2.5
2.0
1.5
1.0
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Consensus Economics - 2-3 years Survey of Private Sector Forecasters - 2 years
Sources: Consensus Economics and Department of Finance Canada
Last observation: 2017Q3
Figure 1: Anchored expectations and the success of inflation targeting
Reviews and renewals
While inflation targeting itself was very innovative, even more so is the joint
agreement and its renewal process. For each renewal, the Bank conducts a
deliberate, rigorous and transparent research program to critically examine
important issues related to the policy framework. Based on this analysis, we
adjust and improve the framework.
We examine two types of issues in the renewal process: fundamental and
operational. Fundamental issues include whether the target for monetary policy
should be changed, and to what extent monetary policy should consider financial
stability concerns.12 Operational issues include how to measure underlying or
core inflation.
Given the policy's effectiveness, the renewals have gone smoothly. But, I can
assure you, they are not automatic. The issues we research are based on
monetary policy experience, primarily in Canada, but also in other jurisdictions,
and on academic and policy-related discussions and research. We also consult
widely, most notably with the Department of Finance, as well as other central
banks, policy institutions and the private sector. All our research, as well as a
comprehensive background document, is published on our website.
The renewal process has evolved over time as our experience and
understanding of inflation targeting has broadened and deepened. Although we
haven't made many changes to the framework, we've gotten better at
operationalizing it. Most notably, having a well-understood and credible inflation
target has facilitated-and indeed demanded-more transparent
communications, since the public can more easily hold the Bank accountable for
monetary policy outcomes.13 To this end, we decided in November 2000 to
announce adjustments to our policy rate on eight fixed dates throughout the
year.14 Four of these announcements are accompanied by our Monetary Policy
Report, which sets out our outlook for the global and Canadian economies as
well as the risks to our projections. Starting this year, the four other decisions will
be followed by a public speech by a member of Governing Council.
Finally, let me give you a quick overview of some of the questions we addressed
in previous reviews.15
In 2011, we asked whether the 2 per cent target should be lowered, and in 2016,
whether it should be raised. Decisions to alter the target rate of inflation require
that we balance two considerations. On one hand, higher inflation is
economically costly. It distorts the price mechanism and is socially unjust
because many people, especially those with lower or fixed incomes, cannot
adequately hedge their financial situation against higher inflation. On the other
hand, higher inflation, if it were credible (which is a big "if"), would give the central
bank a higher neutral policy rate. That's the interest rate consistent with the
economy growing at its potential and inflation staying on target. It serves as a
benchmark for us to gauge the degree of monetary stimulus in place and
provides a medium- to long-run anchor for the policy rate.
The level of the neutral rate is important because, in the event of an adverse
shock, we would prefer to have sufficient room to lower our policy rate to provide
stimulus without the risk of dropping it to zero or below. In some jurisdictions,
policy rates have been lowered to slightly negative levels, but these negative
levels appear to be less effective in stimulating economic activity. For both our
2011 and 2016 reviews, our research found that the 2 per cent target roughly
balances these two considerations, especially since our target is clearly
understood and is very credible.
In both reviews we also examined to what extent the conduct of monetary policy
should take account of financial stability concerns. We concluded in both reviews
that monetary policy should be used only in exceptional circumstances because
it is most effective at achieving the inflation target, while macroprudential policy
has proven useful for mitigating financial vulnerabilities.16 In addition, we found
that post-crisis reforms have made the financial system much more resilient. We
know financial stability is necessary for achieving the inflation target on a
sustainable basis. Therefore, central banks must be mindful of the impact interest
rate changes might have on financial stability and consider adopting a more
flexible horizon over which to return inflation to target. Moreover, well-anchored
inflation expectations provide more scope for central banks to implement a
flexible horizon.
Finally, in 2016, we re-examined how we should measure core inflation. Our
search led us to adopt three new measures. None of them is perfect but,
together, they are giving us a much better reading of underlying inflation than
previous measures did.17
Toward 2021
As I mentioned, our next renewal is in 2021. At this early stage in the process,
we are examining recent economic developments that could affect the resilience
of the Canadian economy. We are also assessing possible measures to
strengthen the monetary policy framework to respond to adverse shocks and
increase overall macro resilience. Three important developments in advanced
economies could pose a challenge to our framework.
First are higher levels of household and public debt Low
(Chart 3, Chart 4).
interest rates have encouraged households to take on debt, and the elevated
level of government debt is largely a legacy of stimulus policies pursued during
the Great Recession of 2008-09. Now, there is less space, on average, across
the G7 for more borrowing to stimulate demand.
Second, over the past 25 years, we've seen a gradual decline in interest rates,
including long-term bond yields and, most importantly, estimates of the neutral
interest rate (Chart 5).18 This reduces the scope of central banks to adjust their
policy rate.
And, third, the trend rate of economic growth has been decreasing, owing to
fundamental forces: lower labour force growth, reflecting an aging population,
and declining labour productivity growth, which is more difficult to explain. The
underlying growth in the economy is expected to remain low or to slow further.
Therefore, the cyclical forces that normally help to propel an economy out of an
unexpected downturn, namely business and residential investment as well as
purchases of large durable goods, may be less powerful, especially if debt levels
are high and confidence is slow to rebound. In such circumstances, policy might
have to be more aggressive to boost confidence and increase demand.
The policy implications of these developments were the focus of our discussions
in September 2017 at a public workshop we hosted at the Bank to launch our
2021 research agenda. We invited Canadian and international academics,
journalists, and economists from the private sector, think-tanks and unions to
suggest ideas for our research agenda for the renewal.19
These ideas can be grouped into three broad sets of issues regarding our
monetary policy framework: its objective, the available tools to achieve the
objective and the potential role of policy coordination. Let me say a few words
about each.
On our objective, one alternative that participants discussed was a switch to
price-level targeting (PLT). Under PLT, monetary policy would seek over time to
keep the price level, rather than the inflation rate, on a predetermined path. This
would imply that past deviations from this path would have to be reversed, likely
gradually, with higher or lower rates of inflation. We researched PLT for the
2011 renewal and, in the end, we concluded that its benefits did not clearly
outweigh the costs and risks of making the shift. But we also said that our
assessment of PLT could change.
Chart 3: Household debt has risen to elevated levels in Canada and the G7
Aggregate household debt as a percentage of GDP, quarterly data
%
110
100
90
80
70
60
50
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Canada G7, excluding Canada (PPP GDP weighted)
Last observation: 2017Q2
Source: Bank for International Settlements
Chart 4: High levels of G7 public debt are a legacy of post-crisis fiscal
stimulus
General government gross debt as a percentage of GDP, annual data
%
130
120
110
100
90
80
70
60
2000 2004 2008 2012 2016
Canada G7, excluding Canada (PPP GDP weighted)
Source: International Monetary Fund via Haver Analytics Last observation: 2017
Chart 5: Real interest rates have declined since 1990
Long-term real government bond yields in advanced economies, quarterly data
%
9
6
3
0
-3
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Canada G7, excluding Canada (PPP GDP weighted)
Sources: Bloomberg and Consensus Economics Last observation: 2017Q4
What about our tools? In recent years, central banks have used various tools to
ease monetary conditions and stimulate demand when their policy rate was at
the effective lower bound.20 For example, in 2009 we issued a conditional
commitment to keep the key policy rate unchanged for a year, as long as the
outlook for inflation didn't change. Other central banks also used such explicit
forward guidance as well as large-scale asset purchases, typically of government
securities, for this purpose. Further research is needed to examine the
effectiveness of these tools and how best to use them.
Finally, the experience during the crisis, when both aggressive monetary and
fiscal stimulus were used, highlighted the benefits of simultaneous policy action.
Although monetary policy is normally seen as the most effective countercyclical
policy tool because it can respond flexibly and nimbly to adverse shocks, it may
need support from other policies more frequently in the future. Indeed, studies
have shown that when rates are at the effective lower bound, countercyclical
fiscal policies, such as automatic stabilizers, and discretionary policies, such as
infrastructure spending, are highly effective. Our agreement with the federal
government includes a commitment by both the Bank and the government to the
inflation target. That means all economic policies-including monetary, fiscal and
macroprudential-can work together in a complementary fashion for this
purpose.21
More explicit coordination of fiscal and monetary policy would raise governance
issues for both the government and the Bank, given our respective mandates.
One interesting suggestion that came up at the workshop was to focus our
research on ex ante mechanisms to coordinate policies, because complementary
frameworks could deliver better outcomes.
Conclusion
Let me conclude.
Canada's experience with inflation targeting has been much more successful
than originally expected. In hindsight, we underestimated how powerful anchored
inflation expectations would be in helping to keep inflation close to target.
Our policy framework continues to work, and work well-inflation and inflationary
expectations remain firmly anchored. The framework's strengths are the
following:

It features a clear, simple and well-understood target-a focal point.

The agreement with the government underpins its credibility.

And, finally, it is continually improved through the renewal process to ensure
that we are able to meet future challenges.
A strong framework enhances the resilience of the economy, making it better
able to weather adverse shocks. An important recent example of such a shock
was the sizable oil and commodity price declines in 2014 and 2015. The policy
rate reductions we made in 2015 in response to this shock were effective in
facilitating the economy's adjustment and returning inflation to target.
In coming speeches in this series on the review of our framework, we will finalize
and share with you the research questions we will be working on leading up to
the 2021 renewal.
We continue to believe that the best contribution the Bank can make to improving
the performance of the Canadian economy is to ensure that inflation remains low,
stable and predictable.