I recently read the background document that the Bank of Canada released with the renewal of their inflation targeting regime with the Government of Canada.
Not surprisingly, the Bank’s primary focus on what should be the optimal level of inflation is the one that ensures that they continue to be relevant when it comes to policy potency. This requires having a level of inflation high enough to give them room to maneuver above the effective lower bound (ELB). As the name suggests, this is the absolute bottom level that economists believe short term interest rates can base. For centuries, this level had been assumed to be zero. This is no longer the case, as is evidenced in many countries.
To explain, one can imagine nominal interest rates being made up of two components. The first is the inflation component that compensates the holder of the security for the expected loss of purchasing power incurred by inflation over the holding period. The remainder can be viewed as the real rate of return that the investor will receive after inflation. This compensates for, among a few things, the value of the investor not being able to spend his cash immediately.
As an example, if inflation is expected to be 2% and the real rate that the investor needs is 2%, the nominal rate would be at 4%. If the economy required monetary stimulus when short term rates were at this level, then theoretically the central bank could cut interest rates by 400 basis points before hitting zero.
In reality, the neutral rate of interest has moved down. This is the rate that theoretically neither adds stimulus to the economy nor detracts. Evolving demographics and changes to investment, have led the central bank to lower their estimate of the nominal neutral rate to somewhere around 3% from between 4-5%. On face value, this suggests that if the Bank needed to add stimulus, there is less room to move.
What is a central banker suppose to do? The ones who never leave the building suggest just raising the target level for inflation. This seems to be hard to swallow, given the difficulty all central bankers are having at attaining their lower inflation targets now in the real world.
The other response is to assume that zero is no longer the effective lower bound for short term interest rates. If the lower bound is -1%, then you have just as much room despite the neutral rate having been lowered. Internal work at the Bank, suggests to them the lower bound in Canada is minus 50 bp. Moreover, with other monetary tools at the disposal of the central banks, they can influence the yield curve as if front end rates were much lower. These new tools include forward guidance (where the monetary authority tells you that she will keep rates low for a certain period of time conditional on some target), quantitative easing (where the central bank buys government securities further out the yield curve) and credit easing (where securities issued by non government entities are purchased).
Given the new tools and the lower effective floor for rates, the Bank has decided to leave the inflation target at 2% as they believe they continue to have sufficient monetary policy potency to minimize costly volatility of output.
But does the Bank still have sufficient policy effectiveness given this new tools? There is little doubt that these measures have been successful at lowering currencies, rates and yields in other countries but as the Bank notes, “data limitations and economic developments in the wake of the crisis make it difficult to precisely identify the impact of any policy measures.” Later it states that “they cannot access the longer term effectiveness of these policies, particularly regarding their impact on economic activity and inflation.”
Despite the move down in the neutral rate, the Bank justified leaving the target level of inflation at 2% based on the fact that monetary policy can still be effective given the additional tools at its disposal. This is despite their admission that these tools, in the longer run may or may not be effective on economic activity and inflation. I suppose they will get back to us later on that, once they know. On the margin, the justification seems weak, but I guess if the inflation target ain’t broke, don’t fix it.
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