By Gregor W. Smith, Queen’s University

The Bank of Canada often describes inflation targeting as flexible. For example, the preamble to its October 2018 Monetary Policy Report says:

“Canada’s inflation-targeting framework is flexible. Typically, the Bank seeks to return inflation to target over a horizon of six to eight quarters. However, the most appropriate horizon for returning inflation to target will vary depending on the nature and persistence of the shocks buffeting the economy.” [3]

The flexibility thus involves a deferral in the planned return of the inflation rate to 2%, the mid-point of the target range. This deferral is applied because policy is being used to respond to some other goal. One can read more about this strategy in speeches by Bank of Canada officials or in the background documents at the last two renewals of the inflation target [1,2].

Since 2003, the Bank of Canada has published its forecasts (also called projections) for CPI inflation and output growth each quarter in its Monetary Policy Report. Figure 1 shows the projections for inflation (on the y-axis) graphed against the quarter (on the x-axis) for horizons (labelled h) 3–8 quarters ahead. If the return to 2% has been postponed beyond 6–8 quarters then the Bank’s own forecast for inflation will differ from 2% at those horizons.

My recent research suggests two simple ways to measure how much flexibility has been practiced [4]. First, I see whether the projection for inflation at each horizon is correlated with current or lagged inflation or output growth at the time of the Report. The idea is that current events, such as unusually high inflation or unusually low output growth might lead policy-makers to defer returning to 2%.  

Second, I see whether the projection for inflation at each horizon is correlated with the projection for output growth at the same horizon. This correlation tests for flexible inflation targeting as described and recommended by Svensson (2003) and Woodford (2007).  Here is the idea. Tightening monetary policy by increasing the overnight interest rate tends to lead to lower inflation and also lower output growth in the future. But if the projection involves output growth that is unusually low then the Bank of Canada might slightly compromise its inflation goal in order to stabilize output growth. In other words it will be less likely to raise the short-term interest rate it controls and so will risk inflation’s being above target. As a result, the forecast for inflation will be higher than it otherwise would be.

The results of statistical tests for both correlations are easy to report. The correlations are statistically significant but not economically significant. For example, the inflation projection is indeed related to the output projection, but the scale of the effect is extremely small. If the projected growth rate for output is 1 percentage point below its targeted value (a large shortfall in growth) then the projected inflation rate will be only 2.035% rather than 2%.

While I’ve reported on these two ways to measure flexibility, it is possible there is some other factor that explains variation in CPI inflation projections. But presumably the Bank of Canada would say if it was systematically adjusting for such an important factor. And running many regressions to detect it would likely lead to false positives.

Flexibility in inflation targeting remains part of the central bank’s toolkit. It will be difficult to measure its benefits (or costs) in recent history, though, simply because it seems to have been untried so far.

References

[1] Bank of Canada (2011) Renewal of the Inflation-Control Target: Background Information—November 2011. Ottawa: Bank of Canada.

[2] Bank of Canada (2016) Renewal of the Inflation-Control Target: Background Information—October 2016. Ottawa: Bank of Canada.

[3] Bank of Canada (2018) Monetary Policy Report – October 2018. Ottawa: Bank of Canada.

[4] Smith, Gregor W. (2018) Two Types of (Slight) Flexibility in Bank of Canada Projections, 2003–2018. Mimeo, Department of Economics, Queen’s University

[5] Svensson, Lars E.O. (2003) What is wrong with Taylor rules? Using judgment in monetary policy through targeting rules. Journal of Economic Literature 41, 426–477.

[6] Woodford, Michael (2007) The case for forecast targeting as a monetary policy strategy. Journal of Economic Perspectives 21(4), 3–24.