The inflation-targeting framework bolsters credibility because it is very transparent.
Knight: In the 1970s and 80s, Canada experienced high and variable inflation. At times when inflation rose, the Canadian dollar tended to depreciate, and that fed back into a higher inflation rate. Partly because of this vicious circle, Canada’s macroeconomic performance during the 70s and 80s was weaker than it could have been. As a result of this experience, Canadians came to realize that our country needed a clear nominal anchor for monetary policy if its floating exchange rate was to do an effective job in helping the economy to adjust to external shocks. And the best nominal anchor that the Bank of Canada could find was a direct target for low and stable inflation.
Canada adopted its inflation-targeting regime in 1991, during a time when the inflation rate was more than 4 percent a year. The authorities wanted to bring the annual inflation rate down to a range of 1 to 3 percent, but without severe adverse effects on output and employment. To do this, the Bank of Canada embarked on a gradual path of disinflation. In the wake of the 1990-91 recession, inflation came down more quickly than expected, and over the past nine years it has stayed at close to 2 percent on average.
In terms of better economic performance, Canada really didn’t see the benefits of low inflation until the move to reduce fiscal deficits at the federal and provincial levels began in earnest in 1995. This strengthening of fiscal policies has led, more recently, to a declining trend in the ratio of public debt to GDP. With this move, interest rates under the inflation-targeting policy also came down. All in all, I’d say that since 1996 the combination of our solid record in maintaining low inflation and enhancing fiscal policies has been a major contributor to the improved economic growth and declining unemployment rates Canada has seen.
Knight: The inflation target is jointly agreed between the government and the Bank of Canada. There have been three such agreements since 1991. The current one remains in place until the end of this year,2001. The target range has been 1-3 percent a year since 1995, and this range has been broadly viewed as appropriate for maintaining low and stable inflation, increasing the credibility of monetary policy, and—over the past five years—underpinning steady growth in output and employment.
We target the middle of the 1 to 3 percent range over time. For operational purposes, the Bank of Canada uses “core inflation,” a measure that generally conforms to the total consumer price index (CPI) over time but excludes the more volatile energy and food commodities and the effects of changes in indirect taxes. At present, total CPI inflation is about 3 percent, reflecting the effect of energy prices that have been rising sharply since early 1999, but core inflation is about 2 percent.
Ultimately, of course, households and business-people are concerned about the overall rate of inflation. So if the divergence between core inflation and total CPI inflation were to persist, we would want to make sure that the overall inflation rate remained in the 1-3 percent range.
Knight: The inflation-targeting framework bolsters credibility because it is very transparent. Maintaining low and stable inflation, within a 1-3 percent target range, is a very clear goal that the average person can understand. It resonates with people because they know we are trying to watch changes in the cost of living and keep it low. The transparency of this target also helps our two-way communication with the financial markets and the general public. It makes it clearer that whenever we act, we are doing so to keep the future trend of inflation within the target range. Then, we can interpret market and media reactions to our policy actions to determine whether they think we are doing the right thing.
The credibility of the inflation-targeting policy can be measured by whether expectations of future inflation are broadly consistent with the level we are targeting. For several years now, the available indicators have consistently suggested that the financial markets and the general public expect an inflation rate of about 2 percent a year, which is right in the middle of our target range.
Knight: The basic law governing the operations of the Bank of Canada—the Bank of Canada Act—sees it as an independent institution. The law also sees the gov-ernor—or in his or her absence, the senior deputy gov-ernor—as responsible for the conduct of monetary policy. That is why the act insists that the governor and the senior deputy governor be people of proven financial experience. They are appointed, on good behavior, for a term of seven years, which gives them a degree of independence. In practice, for some years monetary policy has been formulated by the Governing Council of the Bank, which currently consists of the governor, the senior deputy governor and five deputy governors. In reaching its decisions, the Governing Council takes account of the advice and recommendations of its senior economics staff, gathered together in a group called the Monetary Policy Review Committee.
It’s also important that the inflation-targeting procedures give the Bank of Canada a degree of independence. The target range is agreed upon by the government and the bank, but the bank is responsible for taking the monetary policy actions needed to achieve that objective. That, I think, gives the bank an important degree of independence in the public’s mind. If people believe the bank will always take policy actions to achieve its announced goal of maintaining low and stable inflation, that confidence tends to reduce the costs of building credibility, because people are really focusing on a clear monetary policy objective.
Knight: Although Canada is an advanced industrial country, a relatively large proportion of its production and exports consist of primary commodities. This means that changes in commodity prices affect our terms of trade differently from those of most other advanced industrial countries.
When commodity prices fall relative to the prices of manufactured goods, our flexible exchange rate helps to absorb some of the adjustment more efficiently than would be the case if all the pressure fell on nominal wages and other factor incomes.
But the exchange rate only works well in helping the economy adjust if there is a clear nominal anchor for domestic prices. When people are confident that, regardless of whether the Canadian dollar appreciates or depreciates, the Bank of Canada is committed to maintaining the inflation rate at the same low and stable rate, then business-people know that an appreciation of the Canadian dollar means they are going to have to find efficiencies in other areas of their cost structure if they want to maintain profit margins. Similarly, when the Canadian dollar depreciates, businesspeople know that if they try to pass on the increased Canadian dollar price of imported goods into their prices, the demand for their products may weaken.
High inflation creates a lot of uncertainty in the economy, and people have to use real resources to adjust to that. Low and stable inflation should reduce those costs and allow the economy to perform better. But does it? If you look at Canada in the early 1990s, growth of output and employment was not particularly strong. But this was a period when the Canadian economy was restructuring very deeply in response to worldwide technological changes and intensifying competition, the U.S.Canada Free Trade Agreement, and, later, the North American Free Trade Agreement. At the same time, it was also adjusting to lower inflation under the inflation-targeting regime. And the early 1990s were a time when we still had a lot of problems with the stance of fiscal policies.
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If you look at the years since 1996—a period when there has been a real strengthening of fiscal positions at both the federal and provincial levels, and inflation expectations have become anchored around the middle of our inflation-target range—you see consistently strong growth of output and a steady decline in our unemployment rate to its lowest level in a quarter of a century. You also see a significant strengthening of business investment in machinery and equipment. We hope that these are signs that under low and stable inflation the economy does perform better in real terms. We have seen improvements in productivity growth over the past year or so, and we hope that they will now be sustained over the longer term.
Knight: Canada’s experience suggests that inflation targeting can be a very good element of a monetary regime for a country that chooses to float its exchange rate. For a developing country likely to be subject to economic developments that differ from those that affect its trading partners, it’s important to have a floating exchange rate. And a floating exchange rate will work better in helping the country adjust to shocks if there is a clear nominal anchor for domestic prices. For these reasons, at the Bank of Canada we are convinced that consistently achieving low and stable inflation improves overall economic performance in the longer term.
Another point I would make is that targeting low and stable inflation, particularly in a developing country, really imposes a lot of discipline on fiscal policy. In many developing countries, there is quite a direct relationship between excessive fiscal deficits, monetary expansion, and inflation. Targeting low and stable inflation in a developing country is a way to give a transparent commitment to the public that the authorities will maintain good performance, not only in monetary policy but also in fiscal policy.
Knight: Initial conditions pose a tricky question. If a country has a large outstanding debt stock denominated in foreign currency, variations in the exchange rate are going to have an impact on the debt-servicing profile relative to the country’s export receipts. But this is a transitional problem. You can still move into a framework of inflation targeting. It’s just a question of knowing the maturity of your foreign currency debt and debt service, and structuring the move to the new framework so that it doesn’t create problems.
For example, it would be more difficult for a country like Argentina, with its past history of high inflation and currency depreciation, to shift easily to a flexible exchange rate and inflation targeting. But we can take a different example: Brazil. One factor that seems to make a flexible exchange rate a good choice for Brazil is that it is a large economy with lots of nontraded goods, and this structure ensures that there is less pass-through from exchange rate changes to the domestic inflation rate. I believe that Brazil’s experience over the past two years has shown that the institutional arrangement of a flexible exchange rate and inflation targeting has worked well, particularly since it has been reinforced by a marked improvement in the commitment to fiscal stability. Mexico is also doing well under inflation targeting. But since the Mexican economy has a much larger traded goods sector, the authorities have to be more conscious of the pass-through effects.
Knight: If a country has a totally open economy and no nontraded goods, then it may want to peg its exchange rate and accept the world inflation rate. A hard exchange rate peg or membership in a currency union is a good way to stabilize the domestic price of consumer goods. In a small, open, oil-exporting country, for example, movements in the exchange rate would have little effect on the profitability of petroleum exports. Such exchange rate pegging arrangements also help to maximize the microeconomic gains from international exchange. But when an economy has non-traded goods and services—and certainly labor is a nontraded service—then it may well be better to allow the currency to float. But I guess that, to repeat my main message, if you float, you absolutely must have a clear nominal anchor.