If you’ve grown resentful of the never-ending 2015 election campaign, and you feel like punishing the next candidate you see, here’s a suggestion: Ask him or her whether he or she thinks the Bank of Canada should continue using the core inflation rate as its North Star. Then sit back and enjoy the blank stare.
With this simple question, you would be exacting revenge for all the simplistic rhetoric and cynical policy proposals that have dominated the debate about the economy to date. You also would be raising a crucial economic issue that the winner of the October vote will face within months of forming a government.
The Bank of Canada’s marching orders are up for renewal in 2016. The central bank works at a distance from politicians. But every five years, the governor and the government agree on how the monetary authority will approach its duty of keeping inflation advancing at a pace that is neither too fast nor too slow. By next year, there are questions to answer about what data should guide policy and the extent to which preventing asset-price bubbles should influence the benchmark interest rate.
Bank of Canada Governor Stephen Poloz said September 21 in Calgary that it is possible that his sextant could be malfunctioning. The central bank’s objective is to keep annual inflation comfortably in a range of 1–3%. That’s difficult because the consumer price basket is influenced by volatile items such as energy and food. So policy makers focus on “core inflation,” which ignores changes in prices for fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation, tobacco products and indirect taxes. If core is on target, the central bank is comfortable its policy is working.
Or at least it used to be. The post-crisis relationship between core inflation and total inflation looks like this:
The two measures are out of tune. (The Bank of Canada assumes they will converge in the future, but that is based on the assumption monetary policy works as it always did. That’s a bigger assumption these days than it used to be.) The divergence of core and total inflation is important because the central bank’s best means of controlling prices is convincing economic actors—households, executives, investors—that it has a handle on things. If the public starts to doubt, it may demand higher wages or payments to compensate for expected price increases, or delay investments or purchases in anticipation of deflationary pressures.
Poloz said in Calgary that the weakness of headline inflation is exaggerated by the collapse of commodity prices. Nor is core as hot as it looks on paper, he said; the decline in the value of the dollar from a year ago is making imports more expensive. Both conditions should pass, according to the central bank. Still, Poloz is wary that these measures risk spreading confusion and doubt. He said the central bank will be spending time on investigating whether there is a better way to measure trend inflation than the core rate policy makers follow now.
It is sort of surprising that the Bank of Canada only wants to tinker with its inflation-targeting regime. This approach to monetary policy was under assault after the financial crisis, as experts noted the central banks had deluded themselves into thinking that their job had become as simple as keeping inflation at 2%. There was a lot of discussion about doing things differently. It was a great debate that changed very little.
Canada’s central bank, one of the first to adopt an inflation target, is as committed to the policy as ever. A new staff report by the International Monetary Fund concludes that, generally, monetary policy makers should avoid raising interest rates to deflate asset-price bubbles. “In principle, monetary policy should deviate from its traditional response only if costs are smaller than benefits,” the authors state. “Based on current knowledge, the case for leaning against the wind is limited, as in most circumstances costs outweigh benefits.”
That’s a significant finding, as the Bank of Canada and the Finance Department also will be discussing how financial stability should factor in interest-rate decisions. It is a question of whether it is right to inflict short-term pain to reduce the risk of longer-term devastation. The IMF says, for the most part, that the answer is, “No.” Here’s another picture from the Bank of Canada that explains why:
The surge in Canadian household debt is a problem. But as the graph on house prices shows, it probably would be unproductive to increase borrowing costs to contain a problem that is isolated to two provinces. Ultimately, that will be a decision for the finance minister and prime minister after Oct. 19. True contenders for those jobs should be willing and able to discuss monetary policy now. The lucky contestants will be deciding on the specifics of the Bank of Canada’s mandate for the next five years. Given what central banks have been asked to do in recent years, it could be the most important economic policy decision the new government makes.
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