Why Bank of Canada, US Fed Should Adopt Lower Inflation Targets

June 28, 2017 Updated: September 4, 2017

The Bank of Canada and U.S. Federal Reserve are used to being questioned about how they set interest rates to govern the economy. With the two central banks chomping at the bit to raise rates while inflation sputters, many question what the inflation target should be and if a policy error is being made.

The central banks’ primary mandate is to ensure a low and stable level of inflation. One can make a good argument that they’ve achieved this in aggregate.

The latest inflation reading in Canada showed the consumer price index (CPI) rose just 1.3 percent, down from 1.6 percent a month earlier. The Bank of Canada’s three measures of core inflation, which exclude volatile items, average 1.33 percent.

Inflation in Canada (Courtesy Bank of Canada website)
Inflation in Canada (Courtesy Bank of Canada website)

The Fed’s preferred inflation measure has been falling in 2017 despite essentially full employment and economic growth slightly higher than the Fed’s long-run projection. Inflation has been below 2 percent since May 2012.

Both central banks target 2 percent inflation. There have been suggestions for a higher inflation target to allow the economy to run hot given the slow growth era. The BoC analyzed a higher target in October 2016 as part of its inflation target renewal, but stuck with 2 percent.

The Bank of Canada reiterated that its inflation target is symmetric—it is supposed to be equally concerned about inflation rising or falling below 2 percent. However, the Bank’s change of stance in June indicate less concern for below-target inflation.

According to a June 28 Bloomberg report, the odds of the Bank of Canada raising interest rates in July are up to 69 percent after governor Stephen Poloz’s comments.

He reiterated what he and his second-in-command said two weeks earlier when they took a decidedly more upbeat tack on the economy and hinted at an earlier-than-expected rate hike.

Back in 2011, the BoC examined setting a lower target, but had concerns about reaching the lower bound for interest rates.

Markets feel central banks are getting behind the inflation curve and they might have to catch up.
— Sal Guatieri, senior economist, BMO

But BMO senior economist Sal Guatieri, who advocates lowering the inflation target, says that monetary policy has found solutions to that problem.

“Many central banks have proven they can run very expansionary monetary policy despite the 0 percent lower bound on nominal interest rates, so I don’t really think that is an inhibiting factor … and as a result it probably warrants aiming for a lower inflation target,” he said in a phone interview.

Inflation may well be evolving under rapid technological change.

“Why resist benevolent, long-lasting market forces, such as e-commerce and advanced automation, which are muting inflation and, in turn, supporting spending power, business confidence, and trade competitiveness?” Guatieri wrote in BMO’s weekly flagship publication Focus.

Policy Error

The risk of a central bank “policy error” is high. After all, no entity is responsible for more recessions than central banks that raise rates too aggressively. One harbinger of a recession is a flattening and, especially, inverting yield curve in which the difference between longer-term and shorter-term interest rates narrows and even gets negative.

Canada’s yield curve is near its flattest since last summer and the U.S. yield curve is near its flattest since last fall.

“Markets feel central banks are getting behind the inflation curve and they might have to catch up … forcing the economy into recession to address an inflation problem that was, in a way, created because they were running too loose a monetary policy beforehand,” Guatieri says.

The central banks’ concern is that inflation will overshoot the target at some point in the future if rates don’t rise now. The two central banks appear to be far more sensitive to above-target inflation than below-target inflation. It’s as if they’re actually managing inflation to a target of, say, 1.5 percent.

The problem with providing too much stimulus in the economy to get headline inflation up to 2 percent is that it creates unintended price increases elsewhere. Home prices and the stock market are two places where this unintended inflation is really being seen.

With a “hawkish” BoC and Fed and below-target inflation, the other elephant in the room is financial stability risks such as certain overheating housing markets and the build-up of consumer debt.

Rising interest rates can cool off these risks by making borrowing more costly.

Mohamed El-Erian, former CEO and co-CIO of Pimco, wrote in his Bloomberg column that the Fed’s June rate hike was not a mistake and that one more in 2017 is warranted. “Policy-makers should take seriously the growing risk of future financial instability,” he wrote.

Factoring in financial stability risks, both the BoC and Fed appear to be effectively managing monetary policy toward a lower-than-2-percent inflation target.

Follow Rahul on Twitter @RV_ETBiz

Follow Rahul on Twitter: @RV_ETBiz