In a letter published in The duty of January 25 (“Loss of credibility?”), I was worried about the rise in inflation and the lack of reaction from the monetary authorities. I saw a risk that monetary policy would lose hard-won credibility. The inflation rate was then 5.1%. It was 8.1% in June 2022!
Inflation therefore strayed further from the Bank of Canada’s 2% target. The Bank’s key rate has since risen from 0.25% to 2.5%, but may well have to rise a lot further. Many will suffer from higher interest and inflation rates, for example retirees, as Gérard Bérubé reminds us in The duty of July 30 (“The pension hurts from inflation”).
What caused this inflationary slippage? International shocks and a very expansionary fiscal policy did not help, but the monetary authorities could have countered these factors by tightening their policy sooner. I propose here three factors which could explain why they did not do so. I also discuss possible solutions.
First, central bankers’ inflation forecasts are still largely based on a fairly simple framework linking inflation to the output gap (the gap between the observed level of economic activity and its potential level) and expectations inflationary. The current inflationary slippage shows the limits of this approach, limits already underlined in numerous studies.
It would be prudent to consider other approaches. Why, for example, not give a more important role to money? After all, inflation is the rate at which the value of money falls, which should be explained by changes in the supply and demand of money. The growth of Canadian monetary aggregates was very rapid in 2020-21; signal that perhaps should have been taken more seriously.
Second, inflation targets were introduced in the 1990s in Canada and other countries. The Bank of Canada’s task was then clear: keep inflation close to the 2% target. In doing so, it would help make the economy more stable and efficient. But since then, the attention of monetary authorities, in Canada and elsewhere, has turned to other subjects.
In Canada, for example, the objectives of financial stability and maximizing the level of employment must be taken into account by the Bank of Canada, which complicates its policy. The Bank of Canada has also taken an interest in many subjects that have little or no connection to the instruments of its policy: climate change, pipelines, inequalities, etc. Consideration should be given to refocusing the attention of central bankers on the inflation target, an already difficult task, and leaving it to other agencies to take an interest in other subjects.
Third, can the 2021 election deadline explain why the Bank of Canada has not acted more quickly to counter inflationary pressures? I remind you that inflation was already at 4.1% in August 2021. Researchers have concluded that the electoral cycle could affect the decisions of central banks. Perhaps we should rethink the governance of the Bank of Canada in order to reduce the risk of partisan politics being the cause of suboptimal decisions.