A Primer on Inflation Targeting
Publication No. 2011-111-E
9 November 2011
Brett Stuckey
International Affairs, Trade and Finance Division
Parliamentary Information and Research Service
A Primer on Inflation Targeting
(In Brief)
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(the parliamentary intranet) and on the Parliament of Canada website.
In the electronic versions, a number of the endnote entries contain
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Ce document est également publié en français.
Papers in the Library of Parliament’s In Brief series provide succinct, objective and
impartial overviews of current issues. They are prepared by the Parliamentary
Information and Research Service, which carries out research for and provides
information and analysis to parliamentarians and Senate and House of Commons
committees and parliamentary associations.
Publication No. 2011-111-E
Ottawa, Canada, Library of Parliament (2011)
CONTENTS
1
MONETARY POLICY IN CANADA ........................................................................... 1
2
WHY INFLATION MATTERS .................................................................................... 3
3
PROS AND CONS OF INFLATION TARGETING .................................................... 3
3.1
Pros ........................................................................................................................ 3
3.2
Cons ....................................................................................................................... 4
4
ALTERNATIVES TO AN INFLATION-TARGETING REGIME .................................. 4
4.1
Decrease the Inflation Target ................................................................................. 4
4.2
Broadened Mandate to Mitigate the Effects of Asset Bubbles .............................. 5
4.3
Price-Level Targeting ............................................................................................. 5
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On 8 November 2011, the Bank of Canada and the federal government renewed
their inflation-targeting agreement, which guides monetary policy in Canada.
Monetary policy is focused on how much money is circulating in the economy and
what that money is worth, while inflation can be defined as a persistent rise in the
average price of goods and services or the “cost of living.” The main objective of
Canada’s monetary policy, the conduct of which is the responsibility of the Bank of
Canada, is to keep inflation low and stable.
“Inflation targeting” refers to a system in which monetary policy decisions are made,
implemented and communicated according to a clearly stated inflation target or
target range. Debates about the merits of such a monetary policy framework have
been occurring in Canada for at least two reasons: global instability associated with
the recent financial and economic crisis, and consideration of the merits of changes
to the 2006 inflation-targeting agreement between the Bank of Canada and the
federal government.
Although inflation targeting is thought to be successful in Canada and in other
countries that employ such a framework, some analysts believe that Canada’s
monetary policy regime could be improved through such means as a change to the
inflation target or the target range, a clear mandate for the Bank of Canada to take
action to mitigate the effects of asset bubbles as they appear, and/or a change from
targeting inflation to targeting prices.
This paper describes how the Bank of Canada conducts monetary policy, explains
how inflation affects the economy, identifies some of the pros and cons of inflation
targeting, and mentions several of the alternatives to inflation targeting.
1
MONETARY POLICY IN CANADA
The Bank of Canada Act, enacted in 1934, stipulates in its preamble that the Bank of
Canada shall mitigate “fluctuations in the general level of production, trade, prices
and employment, so far as may be possible within the scope of monetary action.”
The Bank of Canada carries out monetary policy by setting the target for the
overnight interest rate, which is the rate at which financial institutions borrow and
lend one-day funds among themselves. When the Bank of Canada alters this very
short-term interest rate, other interest rates – such as the prime lending rate set by
financial institutions – usually move in tandem with it. Changes in these rates affect
consumers, with implications for upward and downward pressure on prices, and –
consequently – the inflation rate.
Since 1991, the Bank of Canada and the federal government have formally agreed
on an inflation-targeting regime. The initial objective of this joint agreement, which
contained a target inflation rate of the midpoint of a 2%–4% target range, was to
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reduce inflation – as measured by the All-Items, or total, Consumer Price Index
(CPI)1 – from a rate of about 5% in late 1990 to 2% by the end of 1995; in fact, a 2%
rate was achieved in January 1992. A new agreement with a target range of 1%–3%
was reached in 1993, and the five subsequent agreements2 – the most recent of
which was signed in November 2011 – have focused on keeping total CPI at an
annual rate of 2%, the midpoint of that range. In conducting monetary policy, the
Bank also considers “core” CPI, which excludes eight of the most volatile
components in the basket of goods and services that is used to calculate the CPI and
adjusts the remaining components to remove the effect of changes in indirect taxes.
Figure 1 shows core and total CPI,3 and the 1%–3% target range and its 2%
midpoint, since the first joint agreement was reached in 1991. Since 1993, when the
1%–3% target range was agreed to, core CPI has exceeded the upper limit of the
target range once and has been below the lower limit of the target range three
times.4 As indicated in Figure 1, total CPI is much more volatile than core CPI.
Figure 1 – Bank of Canada Target Range for the Consumer Price Index and the
Total and Core Consumer Price Index, January 1991–September 2011
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
Core CPI
Total CPI
Upper Bound
Target
Lower Bound
Note:
The 2% target, as the midpoint of the target range of 1%–3%, was agreed upon in 1993.
Source:
Figure prepared by the author using data obtained from Statistics Canada, CANSIM
table 326-0022.
The Bank of Canada prevents the inflation rate, as measured by total CPI, from
moving outside the target range by making changes to its main policy tool, the target
for the overnight interest rate. Changes to the target for the overnight rate typically
alter borrowing costs for individuals and businesses, thereby affecting consumption
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and investment. For example, increases in economic activity sometimes lead to
upward pressure on prices and thereby inflation. To counteract this pressure, the
Bank of Canada may increase the target for the overnight rate, which tends to raise
borrowing costs and reduce consumption, all other things being equal. With reduced
consumption, there may be downward pressure on prices.
A change in the target for the overnight rate could also affect the relative value of the
Canadian dollar. Through its impact on interest rates set by financial institutions, an
increase in the target for the overnight rate could make investments in Canada
relatively more attractive because of higher expected rates of return. All other things
being equal, a rise in foreign investment would increase demand for the Canadian
dollar and put upward pressure on its relative value. Furthermore, an appreciation in
the relative value of the Canadian dollar makes foreign goods relatively less
expensive and could reduce inflationary pressures associated with demand for
domestic goods and services. The opposite effects would be expected in the case of
a decrease in the target for the overnight rate.
2
WHY INFLATION MATTERS
Broadly speaking, inflation may result from “too much money chasing too few goods,”
for one of two reasons: an increase in household, business and/or government
spending, assuming that supply is constant in the short term, or an increase in the
money supply. Alternatively, or in addition, inflation may be the result of “cost-push
inflation,” which involves increases in the costs of production that lead producers to
pass increased costs to consumers in the form of higher prices.
Volatile inflation makes investment decisions more difficult because the future cash
flow associated with an investment is more uncertain. Furthermore, from the
perspective of the value of money over time, inflation reduces the purchasing power
of those who hold cash and those with fixed incomes.
Although inflation may have negative effects, a general decrease in prices – deflation
– may also be undesirable, in part because it may encourage individuals, businesses
and governments to delay spending as their purchasing power increases over time.
Economists generally believe that a rate of inflation should be stable and low but high
enough to prevent deflation.5
3
3.1
PROS AND CONS OF INFLATION TARGETING
PROS
One of the main arguments in favour of inflation targeting is that it increases public
confidence about the stability of future prices. When a central bank adopts an
inflation-targeting framework, a clear signal is sent that inflation control is a priority.
When this framework is credible and well communicated, people expect prices to be
relatively stable at or around the stated inflation target, thereby allowing consumers
and businesses to manage their finances with greater certainty about the future
purchasing power of their savings and income.
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Adopting an inflation target does not mean, however, that the goal of economic
growth is abandoned. In fact, some believe that controlling inflation is the best
contribution that monetary policy can make to economic growth. According to the
current governor of the Bank of Canada, “[t]he relentless focus of monetary policy on
inflation control is essential … and remains the best contribution that monetary policy
can make to the economic and financial welfare of Canada.” 6
3.2
CONS
Some commentators who do not support inflation targeting note its lack of flexibility,
since it focuses on inflation at the expense of other monetary policy objectives, such
as full employment. For example, inflation targeting may limit the ability to respond
effectively to economic crises, since its focus is relatively narrow.
Furthermore, if an economic downturn and low inflation are concurrent, such as
occurred during the recent financial and economic crisis, an inflation-targeting
framework is limited in its ability to stimulate the economy once it reaches an
effective zero bound. Since the target for the overnight rate cannot be reduced below
0%, if further monetary policy stimulus is required, extraordinary measures may be
required.7
Moreover, the recent subprime mortgage crisis in the United States, and the resulting
financial and economic crisis, have shown another aspect of the inflexibility of
inflation targeting. A number of commentators believe that focusing exclusively on
inflation reduces the extent to which central banks are able to ensure stability in
asset markets, such as the housing market. Although asset prices, such as real
estate, may be growing faster than inflation, core and total CPI may not reflect this
relatively higher growth rate since these measures of inflation consider prices across
the entire economy. Because the narrow focus of an inflation-targeting framework
requires the Bank of Canada to focus on total CPI, rather than on prices in a
particular segment of the economy, monetary policy in this case would be unable to
restrain price increases in the housing market.
4
4.1
ALTERNATIVES TO AN INFLATION-TARGETING REGIME
DECREASE THE INFLATION TARGET
Some commentators argue that price stability, or a situation of zero inflation, would
improve the current inflation-targeting regime in Canada, since even a low rate of
inflation – such as 2% – contributes to an erosion in the value of Canadian money
over time. The Bank of Canada estimates that total CPI is biased upwards by
approximately 0.6% annually;8 therefore, a goal of price stability would aim for a
0.6% increase in total CPI annually. A number of commentators have proposed that
the Bank of Canada decrease its inflation target from 2%, which is the midpoint of the
current 1%–3% range, to either 1% or 1.5%.9
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4.2
BROADENED MANDATE TO MITIGATE THE EFFECTS OF ASSET BUBBLES
The recent global financial and economic crisis has shown that price stability does
not necessarily guarantee economic stability and well-functioning financial markets.
Consequently, some commentators believe that the Bank of Canada’s mandate
should be broadened to enable consideration of asset-market stability in the setting
of the target for the overnight rate. With this modification, if the Bank believed that
assets prices were rising higher and more quickly than normal economic growth
would suggest should be the case, it could increase the target for the overnight rate
more quickly than inflation targeting would dictate in order to mitigate price increases
in asset markets.10
While a number of commentators agree that the Bank of Canada should have some
mandate regarding financial stability, there are concerns that the sector-specific
nature of asset bubbles may mean that monetary policy is too broad an instrument to
be useful in reducing the prices of particular assets without causing undue harm to
the rest of the economy. While the solution to this policy dilemma is unclear, the
current governor of the Bank of Canada has suggested that, while there is a need for
policy tools to address asset price bubbles, the nature of these tools and the manner
of their implementation are unclear.11
4.3
PRICE-LEVEL TARGETING
Price-level targeting is similar to inflation targeting in that both approaches establish
targets for a price index, such as total CPI. However, while inflation targeting is
“forward looking,” 12 price-level targeting takes past years into account when
establishing inflation targets.
For example, if the price level were to rise 1.5 percentage points above the pricelevel target in a given year, the Bank of Canada would set its inflation target in
subsequent periods in a manner that would return the price level to its original target.
In this way, rather than trying to achieve a constant inflation target each year, the
Bank of Canada would attempt to ensure that, in the long run, inflation – on average
– is at the targeted rate.
Implementing a price-level targeting regime could be beneficial. For example, with
this approach, individuals would have greater certainty about the value of their
money in the long run, since deviations from the inflation target would be reversed in
subsequent years, unlike the current inflation-targeting framework where deviations
are not corrected and could become sizeable in the long run.
However, some commentators consider a price-level targeting framework to be
relatively more difficult to communicate to the public, since it is more complicated
than a simple 2% inflation target annually. As well, evidence of the success of pricelevel targeting is limited, since the only country to implement such a policy was
Sweden in the 1930s.13
According to a Bank of Canada representative, although there has been much
research on the topic of price-level targeting since 2006, more research is needed
before the Bank of Canada would recommend such an approach.14
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In announcing renewal of the inflation-targeting agreement between the Bank of
Canada and the federal government, the Minister of Finance said: “At a time of
continuing global economic uncertainty, it is more important than ever to provide a
stable economic environment.” 15
The 8 November 2011 agreement renewed the 2% inflation target, the midpoint of
the 1%–3% target range.16 A joint statement by the Bank of Canada and the federal
government noted, however, that “[t]he Bank will continue its research into potential
improvements in the monetary policy framework. Before the end of 2016, the
Government and the Bank will review the experience over the period and the results
of the research and determine the appropriate target for the years ahead.” 17
NOTES
*
This publication in an updated version of a 2007 paper prepared by Philippe Bergevin,
formerly of the Library of Parliament.
1.
“Total CPI” is a measure of changes in prices. To calculate this measure, Statistics
Canada compares the retail prices of a representative “basket” of goods and services at
two different points in time, and calculates the percentage change in the price of the
basket.
2.
Inflation-targeting agreements have been signed in 1991, 1993, 1998, 2001, 2006 and
2011.
3.
In the short run, much of the change in the total CPI is caused by temporary fluctuations
in the prices of such components of the basket of goods and services as fruit and
gasoline, as well as in indirect taxes. For this reason, the Bank of Canada uses a “core”
measure of CPI inflation, called “core CPI,” as an indicator of the underlying trend in
inflation. This core measure excludes eight of the most volatile components of the basket
and adjusts the remaining components to remove the effect of changes in indirect taxes.
4.
Core inflation rose above 3% in November 2002 and reached 3.15% in January 2003
before returning to the target range in February 2003. Core inflation fell below 1% in
February 1999, September 2000 and, most recently, February 2011.
5.
Low inflation rates are usually preferred to low deflation rates, since decreases in prices
associated with deflation generally lead to lower production, which in turn can bring about
reduced wages, a situation that people are reluctant to accept.
6.
Mark Carney, Governor of the Bank of Canada, “Inflation Targeting in a Global
Recession,” Speech delivered to the Halifax Chamber of Commerce, Halifax,
27 January 2009.
7.
The three key instruments that the Bank of Canada identified for conducting monetary
policy at the effective lower bound are:

conditional statements about the future direction of policy interest rates;

quantitative easing, which involves the creation of central bank reserves to purchase
financial assets; and

credit easing, which includes outright purchases of private-sector assets.
See John Murray, Deputy Governor of the Bank of Canada, “When the Unconventional
Becomes Conventional: Monetary Policy in Extraordinary Times,” Speech delivered at
the Global Interdependence Center, Philadelphia, 19 May 2009.
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8.
The Bank of Canada has outlined four sources of bias in total CPI:

a “commodity-substitution” bias, since consumers sometimes choose to buy less
expensive products when the cost of the product that they usually purchase
increases but the basket of goods and services is updated by Statistics Canada only
once every four years;

a “new-goods” bias, which arises when prices of the products in the current basket
decrease due to new products coming onto the market;

a “quality-change” bias, which occurs due to price changes resulting from changes in
quality; and

an “outlet-substitution” bias, which arises due to a shift in market shares from high- to
low-priced retailers.
See Bank of Canada, “Measurement Bias in the Canadian CPI,” Backgrounders, 2010.
9.
Angelo Melino, “Moving Monetary Policy Forward: Why Small Steps – and a Lower
Inflation Target – Make Sense for the Bank of Canada,” C.D. Howe Institute
Commentary, No. 319, January 2011.
10.
Jack Selody and Carolyn Wilkins, Asset-Price Misalignments and Monetary Policy: How
Flexible Should Inflation-Targeting Regimes Be?, Bank of Canada Discussion
Paper 2007-6, June 2007.
11.
Mark Carney, Governor of the Bank of Canada, “Some considerations on using monetary
policy to stabilize economic activity,” Speech delivered to a symposium sponsored by the
Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 22 August 2009.
12.
“Forward looking” refers to the notion that the policy is only concerned with inflation in the
future, rather than with reversing past deviations from the target.
13.
John Murray, Deputy Governor of the Bank of Canada, “Re-examining Canada’s
Monetary Policy Framework: Recent Research and Outstanding Issues,” Speech
delivered to the Canadian Association of Business Economics, Kingston, Ont.,
24 August 2010.
14.
Ibid.
15.
Department of Finance Canada, “Government of Canada Renews Inflation-Target
Agreement with the Bank of Canada,” News release, Calgary, 8 November 2011.
16.
Ibid.
17.
Department of Finance Canada, “Joint Statement of the Government of Canada and the
Bank of Canada on the Renewal of the Inflation-Control Target,” 8 November 2011.
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