How Flexible is Inflation Targeting in Canada?

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.

SmithJDIMPRFigure1My 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.

 

Understanding Fiscal Policy in a Changing Political Environment

By Raphaelle Gauvin-Coulombe, Queen’s University

Fiscal policy in response to the Great Recession of 2008-09 varied widely across OECD countries. The United States, for example, took an expansionary fiscal stance, adopting an important stimulus package in February 2009 on the order $787 billion (CBO estimate). Canada’s response went in the same direction with its Economic Action Plan, a $30 billion stimulus package enacted in January 2009 (Department of Finance, Canada). Alternatively, on the other side of the Atlantic, policy-makers in the United Kingdom, Germany, and elsewhere either proposed, or implemented, austerity measures. The effectiveness of these different responses is still debated among economists and policy-makers today, and the political drivers of such heterogeneity are still imperfectly understood. Read More »

Universal Basic Income: Our Solution to Automation?

By Kyla Fisher, Queen’s University

Over the past few years there has been increasing discussion in the media about the potential that technological change has in leading large portions of society to be unemployed. On one side, doomsayers point to the rapid progress in automation and artificial intelligence (AI) as signs that human workers will soon be replaced. Their opponents note that these same predictions were made in the past during the industrial revolution and turned out to be incorrect. One thing that does seem clear is that large numbers of jobs are susceptible to automation. A study by Carl Benedikt Frey and Michael Osborne found that 47% of U.S. workers had jobs at high risk of future automation (Frey & Osborne, 2017). The remaining question is whether enough new jobs will be created in other industries that can employ the displaced workers. Whatever your opinion, it is interesting to consider our options as a society if we had a major increase in unemployment. To consider this, let us assume that it’s 20 years in the future and that we are facing a significant reduction in the number of jobs available. What are options? In this article, we’ll consider two of the most popular solutions: universal basic income (UBI) and guaranteed basic income (GBI).

Read More »

Canadian Policy Responses to US Protectionism

By Ian Keay, Professor, Queen’s University

After tearing up a long-standing trade agreement between the United States and Canada, a deeply divided, Republican controlled Congress dramatically raises US tariff rates on products predominantly imported from Canada. The federal government in Canada is faced with an acute policy dilemma – there are strong domestic interests pushing for rapid and dramatic retaliation, while other groups, including farmers and landowners, are not nearly so enthusiastic about the prospect of a trade war with our largest and fastest growing trade partner. To complicate matters further, Canada’s European allies are keen to promote the continued globalization of international markets by keeping trade barriers low. The Canadian government ultimately decides to respond to these conflicting forces by re-writing virtually every line in the domestic tariff schedule, explicitly adopting protectionism as a primary policy goal, and increasing average tariffs by more than 50%.

This series of events probably sounds very familiar to Canadians today, but this particular episode in Canada-US trade relations took place over 150 years ago, during the late 1860s and 1870s. John A. Macdonald’s Conservative government introduced the National Policy tariffs as a response to US protectionism just months after his party won the 1878 federal election. Economists and historians have long understood that this response marked a sharp U-turn in Canada-US relations. However, our understanding of this policy, and its consequences for Canadian growth and development, has been hindered by researchers’ reliance on incomplete evidence.Read More »

Can British Columbia’s Carbon Tax Success Happen Anywhere?

By Nikola Milutinovic, Queen’s University

Carbon taxes aren’t necessarily the job killer some provincial party leaders are making them out to be. Research by Ph.D. Candidate Akio Yamazaki of the University of Calgary should give Canadian politicians and pundits pause over the employment effects of carbon taxes. Yamazaki’s research suggests that British Columbia’s revenue-neutral carbon tax caused a net-gain in employment of 4.5% between 2007 and 2013. Governments can affect the labour market impact of carbon pricing by properly allocating their carbon tax revenues, according to Yamazaki.

Read More »

Smoking Bans Improve the Health of Children and Infants

By Fanny McKellips, Queen’s University

It is a well-accepted fact that smoking and second-hand smoke have harmful effects on health.

For this reason, many measures are taken by governments to decrease smoking and exposure to second-hand smoke. Canadian provinces, for instance, have banned smoking in all public places and workplaces. In the United States, 25 states have banned smoking in public places. While this limits exposure of non-smoking adults to secondhand smoke, it may create a displacement of smoking from public places to homes. Could this mean that children and infants, who cannot make their own decision to be exposed to second-hand smoke, are negatively affected by smoking bans? This issue is not well understood as the literature surrounding smoking bans tends to focus on the health impact on adults. Read More »

Closing the Income Sprinkling Loophole: Fair and Likely Efficient

By Frédéric Tremblay, Queen’s University

The Canadian government has recently announced that it intends to address what it considers to be three loopholes that allow tax planning using private corporations: income sprinkling, passive investments made by private corporations, and the conversion of a private corporations’ income into capital gains. This post will focus on the first form of tax planning, income sprinkling.

Income sprinkling refers to the use of the flexible structure of a Canadian-controlled private corporation (CCPC) to do income splitting with family members in lower tax brackets. This allows some Canadian small business owners to reduce their income tax burden in a way that is unavailable to other Canadians. Finance Canada estimates that closing the income sprinkling loophole would generate $250 million yearly in additional tax revenue[1]. Since the impact on federal finances is likely to be negligible, I focus my analysis on the issues of fairness and efficiency.

Read More »

Welcoming Brent Hickman

By Nora Ottenhof, Queen’s Universityhickman

Queen’s University Economics Department is thrilled to welcome assistant professor, and J. William and Marion E. MacKinnon Junior Fellow, Brent Hickman into the faculty. Brent joined the QED faculty last summer from the University of Chicago. We would like to take this opportunity to highlight some of Professor Hickman’s work and celebrate some of his career accomplishments so far.  

Read More »

Joint Conference on Financial Intermediation at Queen’s Economics Department

By Ken Chow, Queen’s University

On May 8th, 2018, the Queen’s Economics Department hosted the second annual workshop on Financial Intermediation and Regulation, jointly hosted by the Bank of Canada and the John Deutsch Institute. The conference brought together some of the world’s leading experts in finance and industrial organization to present and discuss their latest research. The conference covered interesting topics relating to finance and regulations including the impact of shadow banking on monetary policy [1], the strategic use of trade credit in retail supply chains [2], the dealers’ and investors’ bidding behaviour in Canadian treasury bills auctions [3], and how the current selection process of arbitrators in the US favours the repeat selection of industry-friendly arbitrators. [4]

A key feature of this conference is the emphasis put on the policy implications of academic research. In particular, the rise of the shadow banking sector in the last few decades have attracted the attention of academic researchers, central bankers and policymakers worldwide, making Kairong Xiao’s paper titled “Monetary Transmission through Shadow Banks” a very timely inclusion to the conference. To illustrate the importance of the shadow banking system, note that in the United States just prior to the onset of the great recession, the total shadow banking liabilities exceeded $20 trillion USD compare to $10 trillion USD liabilities in the traditional banking system. [5] Read More »

In Memory of Frank Lewis (1947-2018)

By Eliane Hamel Barker and Ardyn Nordstrom, Queen’s University

On March 14th, 2018, Frank Lewis passed away peacefully at home. Frank had been an Emeritus Professor for the Department of Economics at Queen’s University, where he spent 44 years of his career before retiring last year. He received his doctorate in Economics from Rochester University after graduating from Westmount High and McGill University.

Frank was devoted to teaching and mentoring students for many generations, and was an active researcher with a focus on Canadian economic history. His teaching legacy was recognized in 2016 when he received the Jonathan Hughes Prize for excellence in teaching from the Economic History Association. Even after retiring, Frank continued to contribute by publishing two academic papers and providing expert assistance to the Indigenous and Crown parties in a significant case involving 1850 treaties. The Queen’s Economics Department will always remember Frank Lewis for his years of contribution and for sharing his passion for economic history. You can read more about Frank’s illustrious career here.

A memorial service in Frank’s memory will be held on Thursday, May 3rd, 2018 in Grant Hall, Queen’s University. The ceremony will start at 2:30pm and will be followed by a reception at Ban Righ Hall in the Eliza S. Gordon Dining Room.

Frank’s full obituary is available here, where you will also find a space to pass along your condolences. Should you wish to donate to the Queen’s Economics Department in memory of Frank Lewis, you can do so here.