Alternatives to the BoC’s inflation target

This post comes from something a former student shared with me. The link they shared is here
The Bank of Canada’s policy target (currently 2% inflation as measured by the CPI) is up for review/renewal this year. This is a good time to look at other options. Let’s examine a few.

1% - this is just silly, the BoJ and Fed have been engaged in a huge experiment in monetary policy with zero or near zero interest rates. The results from the US are not in yet, but I’m not optimistic and there isn’t a lot to suggest it’s been successful in the Japan. I’m more likely to side with raising targets (a la Olivier Blanchard) rather than reducing them.

NGDP targeting – this is a little more interesting. The idea is the central bank targets a combination of price level and output (essentially P*Y), this is sort of what the Fed does in the US. A reasonable target for this might be something like 5 or so, given past growth rates and inflation.

Problem: what happens if you have a wildly good year? Deflation? Ouch. Say we get a year of growth 6% in real GDP, in order to meet the target we’d have to have deflation. If this were only a one way target, it’d be pretty pointless. So I don’t really see this working out.

Status Quo - We’ve got the U.K. which has overshot its inflation target yet again, despite poor performance in terms of output. Canada, on the other hand, has done quite well in terms of meeting its inflation target and having the needs of meeting the inflation target matching the needs of the real economy. In short when inflation has been below its target the real economy has generally been in need of stimulus.

Why is Canada different? I’m pretty sure it has to do with the mix of what we produce and what we consume, and the resulting impact on the exchange rate. Given that we import finished goods a drop in the exchange rate means an increase in the CPI. We tend to export raw materials and import finished goods. The U.K., on the other hand tends to export services (particularly financial services) and import finished goods. When the demand for the financial services they produce fell dramatically output followed suit. The drop in demand for the financial services (their key export) also caused the value of the pound to fall and inflation, as measured by changes in the CPI, rose. Result: The needs of inflation targeting are contrary to the needs of the real economy, increasing the interest rate would likely increase the value of the pound and decrease the inflation rate – but this would hurt exports and output (or at least not help). This makes sense; the U.K.’s export industry is exceptionally pro-cyclical with respect to the current economic crisis.

Canada is in a slightly different situation. While on the surface it looks a lot like what’s going on in the U.K., there might be something a little different about what drives Canada’s exchange rate. Global demand for the kind of raw materials Canada exports tends to be pretty stable. The stability of demand for our raw materials isn’t the only the reason why Canada’s different. When the price of raw materials falls, say due to a lack of demand, the price of finished products tends to fall too. Thus, a drop in the demand for Canadian exports tends to be matched with a drop in the price of the finished products we import. This means that unless the types of goods that are considered key inputs changes radically (this could happen if hydrogen or other alternate transportation fuels work out) Inflation targeting is a good match for Canada.

Of course this is based on a Keynesian interpretation of monetary policy, if you're a follower of Hayek, things are a little different.