Two per cent inflation remains the right target in Canada
Last week, in a speech to the Empire Club of Canada in Toronto, Bank of Canada governor Stephen Poloz (pictured above) said sub-zero interest rates could be deployed if Canada faces future economic weakness. In doing so, he was responding to concerns of many economists that monetary policy could be trapped by the so-called “zero lower bound” to interest rates, where rates supposedly can’t fall below zero.
Recently a number of economists, including Olivier Blanchard, former chief economist of the IMF, have proposed instead that central bank inflation targets be raised. He argues that a higher target with its accompanying higher interest rates would give central banks greater leeway to lower rates when necessary.
Currently the Bank of Canada’s inflation target is subject to the inflation-control agreement between the bank and Canada’s federal finance department that expires in 2016. This agreement sets a mandate for the bank with respect to inflation consisting of a band between one and three per cent, with its midpoint of two per cent commonly referred to as the inflation target. The first mandate was introduced in 1991 when inflation was running at almost seven per cent and set an initial target of five per cent with a gradual tapering to two per cent at the end of the five-year term. The target has been kept at two per cent ever since.
Inflation had reached double digits several times during the decade before the bank adopted the inflation. Since then, with the exception of three years—1994, 2009 and 2013—where inflation fell below one per cent, the bank has been able to keep the inflation rate within the target band. This experience has bolstered credibility in the bank’s ability to maintain the target, giving households and businesses some certainty for economic decision-making. Changing the target and the higher resulting rate of inflation will both be costly for the economy. A higher target will raise uncertainty about future inflation. How quickly will the economy adapt to the new target? How committed will the bank be in the future about the target once they have changed it?
With greater uncertainty about inflation, workers and suppliers will not want to commit themselves to long contracts. Bargaining and contract renewals will be more frequent and will likely be more contentious. Indeed, one benefit of lower and more predicable inflation resulting from the mandate has been a sharp decline in hours lost by union members to strikes.
Greater uncertainty will also affect the pattern of interest rates. Normally, long-term rates are higher than short-term rates due to, among other reasons, uncertainty about future economic conditions. Increased uncertainty about inflation will raise long-term interest rates relative to short-term rates, and these long-term rates are key for household borrowing and business investment decisions.
Higher inflation itself will be costly because the tax system is not geared to inflation. The system would be neutral with respect to wages and salaries because the thresholds and brackets for personal income have been indexed for some time. The system, however, would not be neutral with respect to interest income, capital gains and corporate income. Taxes would bite into the higher interest rates that compensate for the lost purchasing power from inflation, leaving savers worse off. Similarly, capital gains resulting from inflation that just preserve the purchasing power of assets would also be taxed.
Inflation also distorts the impact of the corporate income tax. It effectively erodes the real value of inventory adjustments and capital cost allowances, leaving businesses with a bigger tax burden—even with no change in the tax code.
These flaws in the tax system can be fixed. But such a fix seems unlikely because governments will not want to concede the inflation is a permanent fixture. Indeed, the flaws were not fixed during the persistently high inflations of the 1970s and 1980s.
In summary, any move to raise the inflation target can have costly consequences. It will disrupt labour relations, it will distort the tax system, and it will create greater uncertainty for all participants in the economy.
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