Fed Avoiding Deflation May Depend on Canadian Experiments in CPI-Targeting
Montreal undergraduates may help reshape the Bank of Canada’s monetary policy and give Federal Reserve Chairman Ben S. Bernanke and Bank of Japan Governor Masaaki Shirakawa clues about how to ward off deflation.
About 240 students so far have spent two hours in a 25th- floor computer lab near McGill University, earning an average of C$30 ($29.88) by viewing combinations of economic data, including unemployment and gross domestic product, and then predicting what would happen to inflation. Central bank researchers are taking part in the project to see whether people can make such forecasts more easily if policy makers target specific levels in the consumer price index instead of the inflation rate -- which might help households and companies make better decisions about spending and investing.
The more accurate the test subjects are, the more they earn. One did so well, “we tried to track this person to see if we could hire her,” said Jean Boivin, 38, a Bank of Canada deputy governor who is helping with the research and has also co-written papers with Bernanke.
The experiments will help Canada decide if it should switch from inflation targeting to price-level targeting in 2012 and may help the bank better communicate its policies to the public, Boivin said. The test results also might benefit Fed policy makers, who discussed price-level targets on Oct. 15 and voted Nov. 3 to inject another $600 billion of reserves into the banking system to avoid deflation -- a widespread drop in prices that has plagued Japan for more than a decade.
“Central banks need to know more about how expectations are formed, and so we see that as part of a much broader agenda,” Boivin said in an interview at the Bank of Canada’s Ottawa headquarters in the room where he, Governor Mark Carney and four other policy makers decide on interest rates, including a decision tomorrow that’s scheduled for 9 a.m. New York time.
The ability to make more credible forecasts may reduce the extra yield bond investors demand from corporate and government borrowers to account for rising prices.
“Since it’s not being done anywhere else and it’s certainly new to Canada, the initial investor reaction might be much more cautious and might exert cheapening pressure on Canadian bonds,” said Wan-Chong Kung, a money manager who helps invest $89 billion at FAF Advisors Inc. in Minneapolis.
“As the central bank gains more experience and the market becomes more comfortable with its ability to keep a check on inflation, then maybe ultimately that becomes a very comfortable thing for markets,” she said.
Canadian government bonds have returned investors 5.42 percent so far this year, according to Bank of America Merrill Lynch data, compared with a 4.02 percent return for an index of global sovereign bonds.
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. Canada may again be at the forefront if it switches next year to targeting the consumer price-index level after the expiration of its five-year agreement with the government to target a 2 percent inflation rate.
The main difference between the two systems is how officials take past inflation into account when making decisions about interest rates. With inflation targeting, “bygones are bygones,” the Bank of Canada said in a 2006 paper it published the last time the agreement was renewed. Policy makers who target 2 percent inflation, like Canada’s, will always adjust interest rates aiming to bring about 2 percent inflation, no matter how badly they missed the target in the past.
By contrast, targeting specific CPI levels obliges the bank to adjust the pace of price changes, setting interest rates to engineer quicker or slower inflation to offset past misses.
As long as inflation behaves as the central bank wants, there’s no practical difference between the two policies. Officials who successfully target 2 percent annual inflation for five years will make the same decisions as those who want the CPI to go from 100 to 110.4 in the same period. It’s when inflation is persistently off course, as has been the case in Japan, that the implications of the difference become clearer.
First, the magnitude of interest-rate moves may differ. When inflation is persistently slower than a price-level targeting central bank wants, it may bring CPI back to the desired path by leaving interest rates lower for a longer period of time than it would if it targeted inflation.
Second, and most relevant, is the idea that targeting the price level will help central banks deal with deflation. If consumers and companies expect the CPI will go from 100 today to 110.4 in five years, they will be less likely to delay purchases in the hope that costs will drop, potentially breaking the deflationary spiral of falling demand and prices.
“By providing households and businesses with greater certainty about the price level well into the future,” such targeting “might reduce the risks associated with entering into long-term financial obligations,” the Bank of Canada said in the 2006 paper.
Canada’s Ivey index of business and government spending released today showed its price gauge fell to 60 in November, the lowest in four months. Readings greater than 50 indicate prices increased. Canada’s consumer prices advanced 2.4 percent in October from a year earlier, the fastest pace in two years, Statistics Canada said Nov. 23.
More confidence about price movements would “absolutely” help the economy, said Larry O’Brien, founder of Ottawa-based technology staffing company Calian Technologies Ltd. and a former mayor of the Canadian capital.
Workers would be discouraged from seeking “inflationary agreements” in labor talks, and people would have more guidance when they “don’t know if we’re getting inflation or deflation,” O’Brien said.
While studies have suggested price-level targeting may allow people to predict prices more accurately over longer periods, it has almost no history outside Sweden, which used it in the 1930s to help stop deflation, according to a 1998 paper by Claes Berg and Lars Jonung of Sveriges Riksbank, the country’s central bank.
“There are potential benefits to price-level targeting,” Canada’s Carney told the House of Commons Finance Committee Oct. 26. “It is a powerful mechanism, potentially, to avoid deflation.”
The students participating in the tests were drawn from a database created by the Montreal-based Center for Interuniversity Research and Analysis on Organizations. Jim Engle-Warnick, an associate professor of economics at McGill University, is leading the testing.
Students volunteer through the Internet and sign a privacy and consent form when they come to the lab, which has about 20 private computer work stations, Engle-Warnick, 46, said in a telephone interview. The undergraduates, who represent a variety of disciplines, are paid C$10 for participating and can make about C$5 to C$45 more based on their accuracy, he said.
“They are on time, they are serious,” he said. “I can’t really play the game that well.”
While the identities of students who did the test in the lab can’t be released because of the experiment’s privacy rules, Dina Tasneem agreed to an interview because she took the test as part of a class she was auditing in September.
“We were given detailed instructions on how to go through the experiment, and from that you could see the difference” between the two systems, the 28-year-old doctoral economics student said, adding that the test was neither difficult nor “very easy.”
Prime Minister Stephen Harper said during the 2008 election campaign that he favored keeping the present system.
“I see no reason why we shouldn’t continue with the general inflation targets that we’ve had for the last several years,” he said.
The benefits of a new system could be lost “if the learning curve is too long,” Deputy Governor John Murray said in an Aug. 24 speech. The success of the 2 percent inflation target “represents a relatively high bar against which any future changes must be judged,” he said.
Other research by central banks has mainly “favored price- level targeting over inflation targeting, although the differences are not always large or statistically significant,” Murray said.
Policy makers in other countries would watch “very closely” if the Bank of Canada “does go ahead and adopt a form of price target,” said Spyros Andreopoulos, a London-based global economist at Morgan Stanley. “It’s always good when somebody else does the practical bit for you.”
Fed policy makers discussed “adopting a numerical inflation objective or a target path for the price level” in an Oct. 15 videoconference. The Fed’s monetary policy currently aims to maximize employment and keep prices stable.
A group of lawmakers from the ruling Democratic Party of Japan said Dec. 3 that the central bank should adopt an inflation target to eradicate price declines and help bolster employment. Japan’s consumer prices fell for a 20th month in October.
Shirakawa has said deflation can’t be overcome with monetary policy alone, and excessive bond buying by the Bank of Japan might be interpreted as monetizing government debt, possibly causing rapid inflation.
Even if the Bank of Canada keeps its current target, the student project will provide insight into how people form price expectations, Boivin said. The tests use different scenarios to help the bank learn the best way of explaining the two systems, and officials plan to refine the tests before trying them on a “representative” sample of people beyond the undergrads, he said, adding that policy makers could use the results to change their economic models and public communications.
“It’s important for monetary policy, but it’s also important more broadly to understand how people behave,” Boivin said.
The Bank of Canada also is considering lowering the 2 percent inflation target and whether it should use monetary policy to help ward off future asset bubbles.
Adopting a price-level target in 2012 “might be a bit of a jump, given how jittery people are,” said William Robson, president of the nonpartisan C.D. Howe Institute in Toronto and head of its Monetary Policy Council, which makes interest-rate recommendations to the Bank of Canada. Even so, he hopes next year’s agreement “will open the door to something more ambitious” in the future, he said.