In 1991 the Bank of Canada (Bank) adopted a policy of targeting the rate of inflation (defined as the year-over-year growth rate of the consumer price index). This policy has been a resounding success. In the decades that followed, the inflation rate hovered around 2%. Deviations from this figure were temporary in nature. The population then became more and more convinced that the Bank could and wanted to keep inflation around 2%. The target was therefore credible. Everyone’s consumption and investment decisions were easier then, because the future was more predictable.
For the past few months, the inflation rate has been between 4 and 5%, well above the target. Faced with this state of affairs, one would have expected the central bank to have tightened its policy. It did announce, on October 27, the end of its quantitative easing policy (net purchases of several billion dollars of government bonds), but its key rate, at 0.25%, remained at a historically low level. .
To justify its policy, the Bank argued, in its Monetary Policy Report last October, that the labor market was characterized by the presence of excess capacity. This argument strikes me as problematic because, as several studies show, estimating the level of excess capacity is highly uncertain. This argument is also problematic because the unemployment rate, at 5.9%, is quite low when compared to the historical average or to estimates of the trend unemployment rate. In addition, labor shortages in several sectors seem incompatible with the presence of excess capacity.
As Gérard Bérubé reported in The duty January 18, consumer and business surveys show that they expect inflation to stay above the 2% target for some time. There is a risk that people will stop believing that the central bank is really aiming for, or capable of achieving, the 2% target. One might think, for example, that the Bank is keeping interest rates low to help finance the very large budget deficit. One could also believe that the instruments of monetary policy no longer work. It would be a great shame if monetary policy lost the credibility acquired at the cost of much effort.