The Bank of Canada said its 2 percent inflation target allows policy makers the flexibility to take extra time to meet their goal in situations such as a severe shock or economic slowdown.
Governor Mark Carney will keep using a horizon of 18 months to 24 months to bring inflation back to target in most cases, while using discretion when financial or economic conditions require otherwise, the Ottawa-based central bank said today.
“These lessons reinforce the value of Canada’s flexible inflation-targeting framework, including its ability to respond to external shocks and its occasional role in supporting financial stability,” said the background paper providing detail on yesterday’s renewal of the target through 2016.
The report adds to Carney’s argument that the current economic recovery will take longer than past recessions because of the global financial crisis, and that the 1 percent benchmark interest rate may not return to normal levels by the time output does. Central banks in the U.S. and the U.K. have also cut their key rates to 1 percent or less to sustain growth threatened by Europe’s fiscal crisis and high unemployment.
“If they were very rigidly moving interest rates up to make sure inflation hits a target at a certain date that’s risking economic growth,” said Dawn Desjardins, assistant chief economist at Royal Bank of Canada in Toronto. “That would be a bigger risk.”
Investors aren’t predicting inflation will diverge much from the 2 percent target even with a 1 percent overnight borrowing rate. The so-called breakeven yield on 10-year government bonds, the gap between regular securities and ones that offer insurance against inflation, was 2.07 percent at 11:39 a.m. in Toronto.
Today’s Bank of Canada report gave three reasons for taking longer to meet its inflation goal -- persistent economic or financial shocks, responses to “financial excesses or credit crunches” and risks that create “a degree of uncertainty” to the economy.
The report also included an analysis on monetary policy and financial stability where it concluded that in “some exceptional circumstances” monetary policy may be an appropriate tool to support the financial system.
“A framework anchored on a solid and credible inflation target provides the flexibility for monetary policy to play an occasional role in supporting financial stability,” it said.
The bank had spent the last five years studying if the targeted inflation rate should be lower or if the level of the consumer price index should be the focus instead of the inflation rate. Both those options were rejected in today’s paper because research showing they may benefit the economy didn’t offset the risks they could introduce.
Canada led the Group of Seven by adopting an inflation target in 1991, a policy about two dozen central banks now use, including the Bank of England and the European Central Bank. U.S. Federal Reserve Chairman Ben S. Bernanke also has expressed some support for establishing an inflation target.
The variability of inflation has declined by two-thirds since inflation targets were adopted, the report said. That in turn has helped reduce interest rates and curbed swings in unemployment, the Bank of Canada said.
Inflation has averaged 2 percent since the Bank of Canada adopted targets in February 1991, compared with an average of 6.9 percent during the previous 15 years, according to data compiled by Bloomberg.
The central bank’s “scope to exercise appropriate flexibility with respect to the inflation-targeting horizon is founded on the credibility built up through its demonstrated success in achieving the inflation target,” the report said.