OTTAWA — Should the Bank of Canada tinker with success?
A leading economist says yes and is asking the central bank to change a policy that most consider has been an unqualified success for almost two decades — targeting annual inflation at two per cent.
University of Toronto economics professor Angelo Melino has issued a report for the C.D. Howe Institute arguing that the bank should lower the inflation target to 1.5 per cent when it comes time to sign a new five-year agreement with Ottawa later this year.
And five years from now, Melino says the target should move south further to one per cent.
Melino, who is a member of the C.D. Howe Institute monetary policy council, agrees that the current framework “is not broken” and has proven its worth in both good and bad times. But, if keeping price gains at two per cent has been good for the economy, then one per cent would be better, he argues.
“There’s nothing magical about two per cent,” he said. “We all see that having inflation at 10 per cent is lousy and at five per cent is also lousy, so the direction to lower inflation is the way we should go.”
The central bank has been thinking hard about what it should do when the current agreement with the federal government runs out at the end of this year almost from the moment it signed the last deal in 2006. At that time, it renewed an understanding in existence since 1991, that the central bank would seek to corral inflation within one and three per cent, aiming for two per cent.
It has not always managed to do that every year, but a look at inflation over the past 15 years shows prices have averaged a two per cent annual rise for the period.
It is that success that many believe will result in bank governor Mark Carney likely recommending that nothing be changed, particularly in the current climate of economic and financial uncertainty.
Merrill Lynch Canada chief economist Sheryl King, who is also on the C.D. Howe policy council, says there are some at the Bank of Canada who agree with Melino, but she adds that it is likely the bank will say it needs more time to study the issue.
“I think the bottom line is they are not going to do anything, it’s still too early,” she says.
On the other hand, some analysts suggest Carney may want to leave a lasting mark on the bank’s history by seeking to improve on a good record.
In speeches the past few years, bank officials have been running ideas up the flagpole to see if anyone salutes, without tipping their hand about which way they may be leaning.
The bank has posed three alternatives. The first is lowering the target as Melino suggests.
Another is moving toward what is called “price level targeting,” which basically means making up for misses — if inflation is three per cent one year, the aim should be to reduce it to one per cent the next so as to arrive at the proper average.
However, that’s exactly what has happened the past 15 years without resorting to price level targeting, so the bank may see this as a moot point.
The third is something officials had given little thought to before the most recent financial crisis — whether the Bank of Canada should use monetary policy to burst asset bubbles and maintain financial stability.
In a speech last August, deputy governor John Murray found some merit in all three options, but also highlighted deficiencies and wondered if the gains were large enough to tinker with a proven system.
“A final factor that must be considered before any decision is made is the proven track record of the present system. This represents a relatively high bar against which any future changes must be judged,” he concluded.
That argues against making dramatic changes, says Melino, but not against trying to improve the system incrementally, especially since there are very few risks.
Lowering inflation would better help individuals on fixed incomes, like seniors, keep up with a rise in the cost of living. Economists say businesses also operate more efficiently if they can count on stable prices.
“My recommendations have only a small upside potential for improving welfare, but the downside risks are even smaller,” Melino says.
And there’s a good reason to experiment, he adds. Canada may one day want to move the target closer to zero, and only by taking baby steps is it possible to test in the real word whether such a goal is desirable.