Bank of Canada weighs inflation target increase

The Bank of Canada (BoC) is reviewing the feasibility of raising its inflation target above 2%, Agathe Côté, a deputy governor, has confirmed.

Such a move would mark a major policy shift in the developed world, where conventional central bank policies continue to be hobbled by the zero-lower-bound (ZLB) six years after the financial crisis.

It would also mark a complete reversal of the thinking that dominated the BoC's research on monetary policy just three years ago. "The bank's research leading up to [2011] strengthened the case for lowering the target," Côté noted on November 18 in Calgary.

But the financial collapse of 2008–09 put those ideas to bed, according to Côté, who warned interest rates are likely to be lower in the future than before the crisis.

"In the mid-2000s, we estimated the real neutral rate of interest to be in the 2.5–3.5% range. Today, we think it is more likely in the 1–2% range," Côté said. "As a consequence, ZLB episodes could become more frequent. Together, these factors suggest consideration should be given to an inflation target that is above 2%."

She added that preliminary evidence for Canada suggests that, in the current environment, the probability of hitting the ZLB "increases from about 5% to about 15% with an unchanged inflation target". That is "not trivial", she said.

But Côté also underscored the need for caution. Changing the target risks unmooring not just inflation expectations, she warned, but the credibility of inflation targeting as a practice.

"The credibility of the 2% target is invaluable. It accrued gradually over time as 2% came to be perceived as a stable and achievable objective," she noted. "Changing the target could cause it to become regarded as temporary in nature. A less-credible target would limit the flexibility and effectiveness of monetary policy as a stabilisation tool."

Côté maintained that Canada – the second country in the world after New Zealand to adopt an inflation-targeting regime – "merits top marks" in that domain, adding the "bar for change is high".

She also noted that while unconventional monetary policies like asset purchases and forward guidance "appeared to provide stimulus", their net benefits have yet to be proven.

The Bank of Canada sets its inflation target together with the government every five years. The current target is the midpoint of a 1–3% range, and was renewed in 2011, meaning the next review will come in 2016.