Bank of Canada Renews 2% Inflation Target for Five Years
Nov. 23 (Bloomberg) — The Bank of Canada renewed an agreement with the federal government to target annual inflation at 2 percent over the next five years.
The agreement was announced by the central bank and the federal government, according to a statement in Ottawa today. The last agreement was for five years and was due to expire Dec. 31.
Bank of Canada Governor David Dodge has said in the past year that the system would be renewed with few changes because it works well and helps him explain monetary policy to the public. Inflation has averaged 2.1 percent since the Bank of Canada adopted targets in February 1991, compared with an average of 6.9 percent during the previous 15 years, according to Bloomberg figures.
“It’s working like a charm,” Don Drummond, chief economist at Toronto-Dominion Bank, said in a Nov. 20 interview. “Even when the oil prices were soaring inflation never wandered very far away from 2 percent. The actual record has been a piece of magic.”
Canada’s central bank will aim to keep inflation at 2 percent as much as possible, and always between 1 percent and 3 percent. To judge future price trends, the central bank will rely on a core inflation index that excludes eight volatile items such as fruit and gasoline and tax changes such as July’s federal sales-tax cut.
Policy makers on Oct. 17 kept the benchmark interest rate unchanged at 4.25 percent, where it’s been since May after seven consecutive quarter-point increases. The central bank’s Governing Council cut its economic growth forecast in October because of weak U.S. demand and a high Canadian dollar that will slow exports.
Set Rates
The Bank of Canada can influence economic growth and inflation by raising the target rate for overnight loans between commercial banks. The overnight target influences the prime rate that commercial banks charge their best customers.
Canada in 1991 became the second country with a numerical goal for inflation, after New Zealand. Since then, more than 20 central banks including the European Central Bank and the Bank of England have followed suit. U.S. Federal Reserve Chairman Ben S. Bernanke also has expressed some support for establishing an inflation target.
Canada’s target may not deserve much credit for slower inflation, J.P. Morgan Securities economist Ted Carmichael wrote in an April paper. Globalization reduced prices of goods worldwide, Carmichael wrote, and Canadian governments cut spending to pare deficits, curbing domestic demand.
Either way, lower inflation and interest rates have boosted Canada’s economy. Mortgage rates fell to the lowest in a half- century in 2005, fueling record consumer spending that has led economic growth for several years.
The country’s benchmark rate has been below the U.S. Fed funds rate since March 2005. Since 1961, the Bank of Canada rate has averaged 1 percentage higher than its U.S. equivalent, according to forecasting firm Global Insight.
Lower Target
Former Bank of Canada Governor John Crow and researchers at the nonpartisan C.D. Howe Institute have said Canada should adopt a tougher inflation target. The 2 percent annual inflation rate means a dollar loses two-thirds of its purchasing power over 30 years, C.D. Howe researchers wrote in a 2004 book.
The Bank of Canada considered a lower inflation target while it was reviewing the policy, and there wasn’t the “strong evidence” required to justify such a change, Dodge said in March.
An inflation target set too close to zero can lead to periods of deflation in times of economic crisis, the International Monetary Fund said in its semi-annual World Economic Outlook published April 13. Getting an economy out of a period of deflation can be much harder than slowing inflation, because central banks can’t set interest rates lower than zero to fight a widespread decline in prices.