Disjoint between central bank actions and objectives diminishes effectiveness of targeting, warns former BoC official
According to many analysts and pundits, inflation risks in Canada remain low in spite of dovish monetary policy, expansionary fiscal policy, and the rollout of COVID-19 vaccinations because inflation expectations are currently set and well anchored. But according to Paul Jenkins, a former senior deputy governor of the Bank of Canada, inflation expectations most definitely can drift.
“Put simply, inflation expectations are a main driver of inflation because expected inflation influences price setting, wage negotiations, and financial contracts – in normal times and in response to unanticipated shocks to the economy,” Jenkins said in an intelligence memo published by the C.D. Howe Institute.
Since Canada started declaring an explicit inflation target in 1991, he noted, expectations have largely remained consistent with Canada’s inflation target. Research from the ‘90s indicated that inflation targets credibly anchored people’s expectations in a fairly rapid and durable manner, and that notion has been affirmed by the country’s subsequent successes in inflation-targeting policy.
But with the economy getting pumped with massive stimulus injections and pressure from pent-up demand building up, a chorus of analysts and academics have aired concerns that inflationary forces are on the rise. Others have dismissed the idea, maintaining that the economy still has considerable slack and central banks continue to be credible as indicated by well-anchored inflation expectations.
However, Jenkins noted that one key element behind central bank credibility is the idea of “time inconsistency.” In the context of monetary policy, he said, that happens when the public sees the central bank performing short-term actions that appear incompatible with its inflation objective, causing the public to doubt the central bank’s ability to achieve its announced inflation target.
“The dynamic at play is that the monetary authorities, in believing that inflation expectations are well anchored, yield to the temptation to boost the economy more than the public expects, leading to expectations being adjusted higher than consistent with the announced long-run policy,” Jenkins said.
One solution to the problem of time inconsistency, Jenkins said, is to have an explicit agreement between the government and the central bank on the goal of the policy. With an easily understood and transparent agreement, the central bank can be held more accountable, which builds and sustains policy credibility – as it has in Canada.
But the amount of stimulus currently in the works, along with the additional planned stimulus to come, could be seen as time inconsistent with the long-run objective of 2% inflation, causing the public to reassess their expectations. The record-setting stimulus bill recently passed by the U.S. Congress, Jenkins added, could create spillover effects that would multiply the risk of the public’s inflation expectations creeping upward.
“As it conducts policy through this challenging and unprecedented period, the Bank must continue to reinforce through its words and actions its commitment to its inflation target in order to benefit from inflation expectations remaining well anchored,” he said.
