January 27, 2011 – The Bank of Canada should lower its inflation target as part of a new monetary policy agreement due at the end of 2011, according to a study released today by the C.D. Howe Institute. In "Moving Monetary Policy Forward: Why Small Steps – and a Lower Inflation target – Make Sense for the Bank of Canada," leading economist Angelo Melino explains why the Bank of Canada should keep its current inflation-targeting regime in the new agreement with the Department of Finance, but make several reforms, including a lower inflation target, to achieve some important goals.
While not ruling out bolder adjustments in the future, the author suggests a number of improvements with modest upside but limited risk for the impending renewal of the monetary policy framework. At a minimum, he recommends the following steps be taken by the Bank of Canada:
- Incorporate past deviations in choosing future inflation targets: the most important payoff to announcing that future inflation targets will reflect past deviations from target is that it could lead to a reduction in medium- and long-horizon inflation uncertainty;
- Announce that it would switch temporarily to price-level targeting (PLT) – a framework where deviations from the inflation target are eventually corrected – if it ever again hits the Zero Lower Bound for the policy rate;
- Lower the inflation target: the Bank should move to a target of 1.5 percent over the next renewal period, with the expectation of a further reduction in the target to 1.0 percent at the subsequent renewal;
- Consider the credit cycle in choosing the policy rate: regulation should be the first tool to deal with the credit cycle, he advises. But markets evolve quickly, and the Bank might need to stretch its flexibility under either IT or PLT on occasion and use its policy rate to help moderate the credit cycle.
Real-world experience with these measures, says Dr. Melino, will help us decide if we should move the inflation target closer to zero or adopt more features of PLT into our monetary policy framework in the future.
For more information contact: Angelo Melino, Professor, Department of Economics, University of Toronto; Philippe Bergevin, Policy Analyst, C.D. Howe Institute, 416-865-1904; email: cdhowe@cdhowe.org