A. Introduction

1. Anniversaries are always a time for reflection, and the fifteenth year of Canadian inflation targeting (IT) is no exception. It is given even greater relevance as it coincides with a renewal of the agreement on the underlying parameters of the IT framework between the Bank of Canada and the federal government. Assessing the link between IT and macroeconomic volatility is crucial to determining the importance of the framework in shaping the Canadian economy and in assessing the potential benefits and costs of change.²

2. The renewal of the IT regime provides an opportunity to determine both the desired level of inflation and the aggressiveness with which IT will be pursued. Canada’s adoption of IT was sealed in February 1991 by a formal agreement over five years between the Bank of Canada and the federal government specifying the inflation objective and the target range, an agreement that has already been renewed three times. In addition, the Bank of Canada has used these renewals as an opportunity to hone its views on the time horizon over which the target should be achieved, and the role and definition of other intermediate targets, such as measures of core inflation.

3. This paper uses a small estimated model to examine the link between the monetary framework and macroeconomic volatility. Following the approach in Bayoumi and Sgherri (2004a, b), we conclude that IT reduced macro volatility primarily through “credibility” effects that lowered inertia in the Phillips curve through more forceful market responses. In light of the success of the present arrangement, the burden of proof for adopting different arrangements should be quite high.

B. The Framework

4. Analysts often use small models to assess the impact of monetary policy on the economy. A typical closed economy approach might involve a three equation model such as the following:

where y is the output gap, r is the real interest rate (current nominal rate less expected inflation), π is annualized inflation, i is the nominal interest rate, ε’s are error terms, superscript e represents expectations, and other Greek letters reflect parameters.

5. The model comprises an IS curve, Phillips curve, and a monetary reaction function. The first equation is a forward-backward looking IS curve, in which the current output gap depends on its past value and expected future value—with coefficients summing up to the discount rate (assumed to be 0.99 in a quarterly model)—and on the real interest rate. In the Phillips curve, current inflation likewise depends on the past and future expected price increases—with coefficients adding up to unity—and on the output gap. Finally, in the monetary reaction function the interest rate depends on a smoothing parameter, the long-term objective and equilibrium real exchange rate captured by a constant term, expected inflation and the output gap.

6. Modern inflation theory suggests that more predictable monetary policy can improve macroeconomic stability. Recent theoretical work has established that inflationary expectations become more forward-looking as uncertainty about future demand is reduced.³ Frameworks such as IT help reduce such uncertainty by imparting more predictability to monetary policy and the inflation process, with the result that economic volatility declines.

7. Policymakers in Canada were among the first to recognize this potential link and relied on it as a rationale for the introduction of an inflation target. For example the then-Governor of the Bank of Canada observed in March 1995 that “by making its inflation-control objectives more explicit, the Bank hoped not only to influence inflation expectations, but also reduce uncertainty in the economy and the financial markets” (Thiessen, 1995). He went on to say that “with credible targets, inflation expectations, and therefore inflation, are less likely to react to temporary demand and supply shocks.” In addition, an inflation target imposed discipline on the Bank as it made “monetary actions more predictable and less a source of uncertainty for others.”

C. Empirical Results

8. Empirical estimates are consistent with the hypothesis that the Canadian Phillips curve has become more forward-looking after the introduction of IT. Using quarterly data, model (1) was estimated separately for two periods, one before the inflation targeting had been introduced (1982-89), and one thereafter (1992-2005):⁴

• The results suggest that the Phillips curve coefficient on forward-looking inflation has increased significantly after the introduction of inflation targeting. The preferred specification involves a rise in the coefficient on forward-looking inflation of almost one third, from 0.54 to 0.71 (Table 1).

Table 1.

Canada: Estimates of Monetary Model¹

¹Estimated using systems GMM with a constant term, the first four lags of inflation, the output gap, and nominal interest rates as instruments. Standard errors, reported in parenthesis, are robust to heteroscedasticity and to a first order moving average process. An asterisk indicates that the coefficient is different from zero at the 1 percent significance level.

Table 1.

Canada: Estimates of Monetary Model¹

	1982–89	Both Periods	1992–2005
IS Curve
Expected output gap		0.507 (.006) *
Lagged real interest rate		–0.008 (.001) *
Standard error of regression	0.492		0.226
Phillips Curve
Expected inflation	0.54 (.130) *		0.71 (.039) *
Lagged output gap		0.030 (.024)
Standard error of regression	1.487		2.110
Monetary Reaction Function
Lagged interest rate	0.699 (.024) *		0.833 (.026) *
Constant term	6.965 (.480) *		0.986 (.711)
Long-run coefficient inflation	0.813 (.088) *		1.532 (.317) *
Long-run coefficient output gap	0.61 (.074) *		–0.230 (.279)
Standard error of regression	1.016		0.851

¹Estimated using systems GMM with a constant term, the first four lags of inflation, the output gap, and nominal interest rates as instruments. Standard errors, reported in parenthesis, are robust to heteroscedasticity and to a first order moving average process. An asterisk indicates that the coefficient is different from zero at the 1 percent significance level.

View Table

Table 1.

Canada: Estimates of Monetary Model¹

	1982–89	Both Periods	1992–2005
IS Curve
Expected output gap		0.507 (.006) *
Lagged real interest rate		–0.008 (.001) *
Standard error of regression	0.492		0.226
Phillips Curve
Expected inflation	0.54 (.130) *		0.71 (.039) *
Lagged output gap		0.030 (.024)
Standard error of regression	1.487		2.110
Monetary Reaction Function
Lagged interest rate	0.699 (.024) *		0.833 (.026) *
Constant term	6.965 (.480) *		0.986 (.711)
Long-run coefficient inflation	0.813 (.088) *		1.532 (.317) *
Long-run coefficient output gap	0.61 (.074) *		–0.230 (.279)
Standard error of regression	1.016		0.851

¹Estimated using systems GMM with a constant term, the first four lags of inflation, the output gap, and nominal interest rates as instruments. Standard errors, reported in parenthesis, are robust to heteroscedasticity and to a first order moving average process. An asterisk indicates that the coefficient is different from zero at the 1 percent significance level.

• The results also suggest that the long-term response of interest rates to inflation has been more forceful in the second period, and interest rate smoothing in the monetary reaction function also increased.

• Other key economic relationships, including the IS curve and the Phillips curve coefficient of the output gap, appear largely unchanged. Overall, however, the results are consistent with Roldos’ (2006) findings that the economy has reacted less strongly to monetary shocks since the introduction of the IT framework.

9. More forward-looking inflation expectations enhanced the expectations channel, reducing the need for aggressive responses to macroeconomic shocks. The impulse response functions from disturbances to the output gap, inflation, and interest rates over the two samples are depicted in Figure 1.⁵ The first two columns of the graph indicate the monetary response needed to stabilize the economy in response to macroeconomic shocks was smaller after the introduction of IT, reflecting the speedier impact of interest rate changes on the private sector. The increased importance of the expectations channel implied by more forward-looking inflation expectations also allowed monetary policy makers to respond to shocks in a more gradual manner.

Impulse Response Functions

Citation: IMF Staff Country Reports 2006, 229; 10.5089/9781451807004.002.A002

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Impulse Response Functions

Citation: IMF Staff Country Reports 2006, 229; 10.5089/9781451807004.002.A002

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Impulse Response Functions

Citation: IMF Staff Country Reports 2006, 229; 10.5089/9781451807004.002.A002

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10. The model’s results track the decline in Canada’s macroeconomic volatility since 1991 relatively well. We compare the actual volatility of inflation, the output gap, and the interest rate before and after the introduction of inflation targeting with volatilities implied by the monetary model (Table 2, first four lines). Although the model does not replicate the actual volatilities very accurately, it does capture their reduction after the introduction of inflation targeting, including in the interest rate as IT made policy responses more predictable.

Table 2.

Standard Deviation of Inflation, Output Gap, and Interest Rate Before and After Introduction of Inflation Targeting¹

(In percent)

¹Rows A and B: actual standard deviations in pre-IT and IT periods; C and D: asymptotic standard deviations based on estimated model (1) for the two periods; E and F: mixing estimated model parameters from one period with estimated standard deviations of shocks from the other; G and H: model-based asymptotic standard deviations assuming the structure of the economy and the shocks are as estimated for the IT period, except row G uses the pre-IT period Phillips curve and row H uses the pre-IT period monetary reaction function.

Table 2.

Standard Deviation of Inflation, Output Gap, and Interest Rate Before and After Introduction of Inflation Targeting¹

(In percent)

	Equation	Shocks	Inflation	Output Gap	Interest Rate
A	Actual	Pre-IT	2.1	2.2	2.0
B	Actual	IT	1.8	1.5	1.6
C	Pre-IT	Pre-IT	4.8	1.5	4.1
D	IT	IT	3.2	0.8	1.6
E	IT	Pre-IT	2.4	1.6	1.8
F	Pre-IT	IT	6.5	0.8	4.8
G	IT MR; Pre-IT PC	IT	6.1	1.2	4.5
H	IT PC; Pre-IT MR	IT	3.2	0.7	1.8

¹Rows A and B: actual standard deviations in pre-IT and IT periods; C and D: asymptotic standard deviations based on estimated model (1) for the two periods; E and F: mixing estimated model parameters from one period with estimated standard deviations of shocks from the other; G and H: model-based asymptotic standard deviations assuming the structure of the economy and the shocks are as estimated for the IT period, except row G uses the pre-IT period Phillips curve and row H uses the pre-IT period monetary reaction function.

View Table

Table 2.

Standard Deviation of Inflation, Output Gap, and Interest Rate Before and After Introduction of Inflation Targeting¹

(In percent)

	Equation	Shocks	Inflation	Output Gap	Interest Rate
A	Actual	Pre-IT	2.1	2.2	2.0
B	Actual	IT	1.8	1.5	1.6
C	Pre-IT	Pre-IT	4.8	1.5	4.1
D	IT	IT	3.2	0.8	1.6
E	IT	Pre-IT	2.4	1.6	1.8
F	Pre-IT	IT	6.5	0.8	4.8
G	IT MR; Pre-IT PC	IT	6.1	1.2	4.5
H	IT PC; Pre-IT MR	IT	3.2	0.7	1.8

¹Rows A and B: actual standard deviations in pre-IT and IT periods; C and D: asymptotic standard deviations based on estimated model (1) for the two periods; E and F: mixing estimated model parameters from one period with estimated standard deviations of shocks from the other; G and H: model-based asymptotic standard deviations assuming the structure of the economy and the shocks are as estimated for the IT period, except row G uses the pre-IT period Phillips curve and row H uses the pre-IT period monetary reaction function.

11. The findings are not related to changes in the magnitude or nature of economic shocks. The lower lines in Table 2 explore the reasons behind the fall in model volatility, distinguishing between the impact of changes in the shocks, monetary policy reaction function, and private sector behavior. The fifth row shows the implied level of macroeconomic volatility had the 1990s economy been subject to shocks that prevailed in the 1980s. The following row reverses the experiment, looking at the volatility of an economy with a 1980s structure buffeted by 1990s shocks. The results suggest that the shocks in the 1990s imposed less output variability but more inflation and interest rate volatility on the economy. On the other hand, the change in the structure of the economy helped reduce variability of inflation and nominal interest rates without a noticeable effect on output volatility.

12. Indeed, the decline in macroeconomic variability is largely associated with more forward-looking inflation expectations. Simply replacing the pre-IT monetary reaction function with the IT-period rule without attendant change in the forward-looking nature of the Phillips curve results in only a small reduction in inflation and interest rate volatility at a cost of higher output gap variability. By contrast, the rise in the expectations component of the Phillips curve explains almost all of the implied reduction in macroeconomic volatility.

13. Looking forward, a key issue is whether a modification of the framework, such as delaying or muting future response to shocks, might affect adversely credibility. Should the markets perceive changes in the monetary reaction function as a weakening of the Bank’s commitment to the inflation target, inflation inertia would likely increase as expectations became less forward-looking. As a consequence, the reduction in macroeconomic volatility seen over the past 15 years might be partially reversed as the private sector would respond more to demand and supply shocks and less to policy action.

D. Conclusion and Policy Implications

14. This paper suggests that the reduction in macroeconomic volatility in Canada after the introduction of inflation targeting is largely attributable to the reaction of the private sector to the establishment of a credible monetary policy framework. With greater confidence in the central bank’s commitment to price stability, the private sector started forming inflation expectations in a more forward-looking manner, reducing the degree of nominal inertia in the Phillips curve. This has attenuated private sector reaction to demand and supply shocks, thus lessening the volatility of inflation and muting the business cycle.

15. An implication of this analysis is that the burden of proof for refinements of the IT framework should be set relatively high so as not to compromise monetary credibility. Potential benefits from adjusting the IT framework should be weighed carefully against the possibility that a perceived waning of the Bank’s commitment to the inflation target could worsen the macroeconomic environment.