Don’t raise the Bank of Canada’s 2% inflation target

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Appeared in the Globe and Mail, March 9, 2023
Don’t raise the Bank of Canada’s 2% inflation target

With the recent decline in the inflation rate, the Bank of Canada has paused its interest rate increases and will wait to see if inflation continues to decrease towards the Bank’s 2 per cent target. Yet at the same time, according to a growing chorus of economists and business leaders, a rigid adherence to the 2 per cent target will depress economic activity and employment in the face of upward pressure on some prices driven by such forces as climate change and population aging.

For example, former IMF chief economist Olivier Blanchard, in a recent editorial in the Financial Times, argued that major central banks should raise their target rates of inflation from 2 per cent to 3 per cent. His rationale is that a higher target inflation rate would increase nominal interest rates. This, in turn, would give central banks more room to lower their policy rates to stimulate economic activity in the event of an economic downturn, without hitting the zero interest rate lower bound.

Once this lower bound is reached, central banks must rely on other monetary policy tools such as quantitative easing or a negative policy rate as was adopted by the European Central Bank. Given the uncertainty about the effectiveness and the unintended negative consequences of quantitative easing or negative policy rates, Blanchard and others favour the more traditional response of reducing the policy rate to a lower but positive level.

But if 3 per cent inflation is preferable to 2 per cent inflation as Blanchard suggests, why not 4 per cent or even 5 per cent inflation?

Blanchard argues that inflation expectations remain well-anchored as long as the inflation rate does not much exceed 3 per cent. But that’s a debatable conjecture. Evidence indicates that higher prevailing inflation leads to more volatile inflation, implying that inflation expectations could become less anchored. This, in turn, would distort price and wage setting, misallocate resources and render monetary policy less effective. Central banks have committed to a 2 per cent inflation target for decades, and inflation in Canada and other advanced economies prior to the pandemic was low, stable and predictable, thereby contributing to a better functioning economy.

If a central bank were to raise its target rate, it would run the risk of undermining public confidence in the central bank’s commitment to maintaining the new inflation target. Consequently, businesses and households would likely expect inflation to exceed the target rather than fall below it, thus making attaining the new target more difficult. However, even if central banks were able to re-anchor inflation expectations at the new target, higher and more volatile inflation would inflict other adverse impacts. In particular, higher inflation is effectively a regressive tax. Reductions in purchasing power tend to be concentrated among lower-income workers less able to recoup such losses with wage gains, and also less able to own assets that increase in value with inflation, particularly housing.

Also, since the tax systems in Canada and other advanced economies are not fully indexed to inflation, taxpayers will bear a higher tax burden as nominal incomes and asset prices increase, even if the inflation-adjusted incomes and asset values do not change. This tax rate drift will distort the incentives to work, save and invest, and thereby reduce productivity and economic growth.

Finally, some advocates for a higher inflation target rate believe that moving the current rate of inflation back down to the 2 per cent target will result in an unacceptably high and persistent rate of unemployment. However, both theory and the evidence from labour markets over the past three decades suggest there’s no long-run relationship between inflation and unemployment. Inflation is ultimately a monetary phenomenon that can be controlled by the central bank.

In the absence of any compelling benefit to increasing the target inflation rate, and given the economic risks and costs of doing so, the Bank of Canada and other central banks should stay firm and maintain their 2 per cent inflation target.

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