The COVID-19 crisis should destroy once and for all the notion that interest rates can be set by math alone.
Tiff Macklem, the new Bank of Canada governor, used his first speech Monday to defend the central bank’s commitment to inflation targeting, a regime he helped design as a young researcher in the late 1980s.
“The message I want to leave you with is that while we are using different tools in these extraordinary times, our policy remains grounded in the same framework,” Macklem said. “The inflation target is our beacon that is guiding our actions as we help bring the economy from crisis, through reopening, to recuperation and recovery.”
That’s a more controversial declaration than it might sound.
There is a rich debate in academia over whether inflation targeting still works as well as practitioners have come to believe. The lockdowns have emboldened critics, who can now argue that the price gauges that central bankers use to guide policy have been rendered unreliable because spending patterns have changed dramatically.
“When it comes to the longer-term recovery, (central banks) inevitably will have to revisit their policy targets,” Jim O’Neill, the former Goldman Sachs Group Inc. chief economist who is now chair of Chatham House, a London-based think-tank, wrote last month. “After all, traditional inflation targeting based on the Consumer Price Index is unlikely to serve any purpose for the foreseeable future.”
The contrarians raised enough doubt that many central banks, including the Bank of Canada, are taking a hard look at the way they set interest rates.
In fact, Macklem will have to make a call next year on whether to stick with the current inflation-targeting regime or recommend that the government adopt something else. The Finance Department updates the central bank’s mandate every five years. In 2017, Stephen Poloz, the previous governor, initiated a “horse race” between the best ideas about how to conduct monetary policy, pledging to subject all of them to rigorous study. The mandate is next up for review in 2021.
O’Neill and others favour scrapping inflation in favour of a target for nominal gross domestic product, which is one of the contestants in the Bank of Canada’s “horse race.”
For now, Macklem is signalling that he has no doubt about the positive outcomes from keeping inflation low and stable. However, he concedes the point that a few months of lockdown might have made his main gauge — the Consumer Price Index — unreliable.
“Total CPI is weighted to reflect the buying patterns of the average Canadian household,” Macklem said. “In normal times, for example, Canadians spend a lot more on gasoline than on alcohol, so gasoline has a larger weight in the index. But these aren’t normal times.”
Here, policy-makers can silence a different group of critics. They don’t have as much influence as they used to, but some economists think interest rates should be determined by mathematical equations involving variables such as the CPI and economic growth. Such a rigid approach could lead to bad outcomes at times like these when the variables have veered from trend.
Last month, the CPI decreased 0.4 per cent from May 2019, the second consecutive decline. Does that mean Canadians are experiencing deflation? Probably not, because much of the downward pressure is coming from gasoline prices and most Canadians haven’t been driving very much. At the same time, weaker inflation is in line with a recession, so the signal remains relevant, but it’s not telling policy-makers how much extra stimulus could be required.
Macklem said the central bank and Statistics Canada are working on the problem.
An early discovery by the Bank of Canada is that the gap between perceived inflation and measured inflation is wider than usual. That’s probably because our understanding of prices tends to be based on the things we buy frequently, not the big-ticket items that eat up most of our disposable incomes.
For the past few months, we’ve been buying a disproportionate amount of groceries, which also happen to represent one of the few sources of upward pressure on the CPI. So even though inflation is at zero, surveys suggest that people think inflation is much higher, Macklem said. That matters because inflation expectations can become self-fulfilling prophecies, and therefore something policy-makers need to take into account when setting interest rates.
“Some of the shifts that we’ve seen in spending patterns are going to unwind as we get back to regular shopping activities,” Macklem said on a call with journalists after the speech. “We’ll really try to look through these temporary effects that are going to unwind and factor in the more enduring effects.”
In the meantime, Macklem and his deputies will rely more on instinct and less on their dashboard. Next month, the central bank will release a “central scenario” of where it thinks the economy is headed, rather than its typical quarterly forecast.
“We expect the quick rebound of the reopening phase of the recovery will give way to a more gradual recuperation phase, with weak demand,” Macklem said. “If, as we expect, supply is restored more quickly than demand, this could lead to a large gap between the two, putting a lot of downward pressure on inflation.
“Our main concern is to avoid a persistent drop in inflation by helping Canadians get back to work.”