The last two years have not been kind to central banks. Inflation in many countries soared far beyond target, reaching levels not seen in decades. Central bankers have responded with necessary but painful interest rate hikes.
Despite disappointment in the performance of many central banks, let’s not lose sight of key lessons. First, inflation stinks, inflicting most harm on those who can afford it least. Second, central banks are the best institutions we have to make sure it goes away and doesn’t come back. As we head into 2024 and inflation continues to fall, it’s worth remembering why the world established central banks and low inflation targets in the first place.
Until the 1990s, central banks struggled to understand and implement counter-cyclical policies. The U.S. Federal Reserve made the Great Depression worse, allowing the money supply to contract by 30 per cent from 1930 to 1933. In a speech in 2002 to honour the 90th birthday of Milton Friedman, the great 20th-century monetarist economist whose Monetary History of the United States detailed that policy disaster, then-governor Ben Bernanke, eventually to be Fed chair, confessed on behalf of the Fed: “Regarding the Great Depression, … we did it. We’re very sorry … We won’t do it again.”
The Bank of Canada did not open its doors until 1935, the second full year of recovery from the Depression, in a country with a small and mostly rural population served by a few banks with branches in the different communities. The economic crisis had been as severe in Canada as in the U.S., leading to significant criticism of the banking system, even though it had survived largely unscathed (unlike in the U.S.). On July 31, 1933, parliament approved the royal commission Prime Minister R. B. Bennett had proposed and less than a year later the Bank of Canada received its charter. Trains ran on time in those days! Two Canadian royal commissioners had voted against a Bank of Canada but two Brits and Alberta Premier John Edward Brownlee carried the day, 3-2. Initially, the bank was privately owned but in 1938 Mackenzie King’s government made it a Crown corporation.
Like many other central banks, the Bank of Canada allowed inflation to spiral out of control in the 1970s in the wake of the 1973 oil price shock. From 1975-82 it tried to reduce inflation by targeting the “narrow money supply” (so-called M1: cash and chequing accounts). Its rationale was the monetarist belief that a direct link ran from money growth to inflation. Any connection there may have been disappeared, however, prompting the bank to abandon the approach, with governor Gerald Bouey famously saying “We didn’t abandon M1, M1 abandoned us!”
From 1982-91, the bank searched for a replacement target for M1 but failed to find one, while inflation and inflation expectations continued at uncomfortable levels.
In February 1991, this all changed when the Bank of Canada, led by governor John Crow, and the government of Brian Mulroney announced explicit inflation targets that gradually stepped down from five per cent to just two per cent in 1995. The joint decision to target inflation directly and to step it down in this way was designed to anchor inflation expectations. Policymakers were concerned that, without explicit targets, shocks like the Gulf War (1990-1) and the introduction of the GST on New Year’s Day 1991 would lead to a repeat of the 1970s.
So, how has the Bank of Canada done in its approximately three decades of targeting inflation?
From January, 1996, when the target officially became two per cent, until this past October, inflation averaged — drum roll, please — 2.1 per cent, which is not bad. By comparison, from March 1962 to December 1990 (the same number of months), it had averaged 5.9 per cent. Moreover, its standard deviation — a measure of volatility and therefore likely of uncertainty about future inflation — has been nearly 60 per cent lower in the inflation targeting era than before it.
But has success in fighting inflation come at the sacrifice of employment or economic growth? Again using standard deviations to measure volatility or uncertainty, and excluding the COVID period because of the wild swings in data its early days caused, the answer is no, in both cases. Consumption spending has been 50 per cent less volatile during the inflation-targeting era, GDP growth 30 per cent less volatile, and unemployment nearly 60 per cent less volatile.
It is tempting to next compare pre- and post-targeting economic growth rates themselves. But doing so is complicated by the fact that they were declining for much of the period before inflation-targeting, which biases the results. Because slower growth has been the norm across developed countries it’s better to compare growth rates in inflation-targeting countries against those in non-inflation-targeting countries. When you do that the evidence has favoured inflation-targeting. As for unemployment, it averaged 7.6 per cent pre-targeting and 7.3 per cent during targeting (again stopping before COVID).
In our view, the evidence is clear: inflation targeting has been a historic success, even with the backsliding into 1970s-style inflation numbers since March 2021. Not everyone agrees, of course. One popular alternative is to retain targeting but increase the target to three per cent, which November’s rate of 3.1 per cent essentially achieved. But part of why inflation has come back down after its recent flare-up is that inflation expectations remained anchored near the two per cent target. If the bank were to raise the target to three because getting back to two per cent was hard, that would lead to expectations it might change the target again next time inflation overshot it. That would destabilize expectations.
From the 1960s through the 1980s, Canada’s economic history was marked by high inflation and economic volatility. We learned from that and did something about it. The regime we introduced in the early 1990s ain’t broke — quite the opposite: it has been very successful — so we shouldn’t try to fix it.
Steve Ambler, professor of economics at the Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, where Jeremy Kronick is associate vice-president and director of the Centre on Financial and Monetary Policy.
Published in the Financial Post
