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The Road to 2% Inflation

25 April 2023

Inflation targeting – How did we get here?

In the long-run, inflation is caused by the central bank’s monetary policy, or as Milton Friedman said, “inflation is always and everywhere a monetary phenomenon.” In the short-run, however, other factors such as energy prices, business cycles, economic shocks and crises also affect inflation. Since it has no long-run positive effect on the economy, limiting the rate of inflation has always been one of the primary roles of the central bank.

Implicit inflation targets were popular in the 1970s and 1980s with both the Federal Reserve and the German Bundesbank setting implicit targets. These banks acted to stabilize inflation around unofficial targets, which were not made public. It wasn’t until the early 1990s that inflation targets were explicit and publicly announced.  New Zealand Reserve Bank was first to adopt a 2% target, and the Bank of Canada soon followed. Since then, the US Federal Reserve, Sweden’s Riksbank, the Bank of Japan, the Bank of England, and the European Central Bank all have the same 2% target.

The difference between an explicit and implicit target is whether the central bank has publicly committed to a specific inflation target rate or range. Making a public commitment to a target may enhance the central bank’s credibility and help to anchor inflation expectations, which in turn helps the central bank reach its target. However, committing to a target limits the central bank’s ability to respond to non-inflation economic events.

The Bank of Canada’s inflation target is flexible – 2% in a 1% to 3% band.  The Bank can deviate from the target for various reasons in the short-run so long as it does not jeopardize the inflation target in the long-run.

Getting to 2% inflation

During the pandemic, the Bank of Canada and other central banks felt that inflation was largely transitory; supply chain disruptions would unwind, and price pressures would ease. Inflation proved to be much more problematic – eventually reaching a 30-year high – and the Bank of Canada and other central banks were faced with a credibility problem.

The international and domestic monetary policy response has been rapid with continued increases in interest rates. We are now on the downslope of easing in inflation. The question is how fast do we get to 2%?

The March inflation numbers registered an annual increase of 4.3%, down from 5.2% in the prior month. Core inflation also moderated by 3-to-4 tenths on a year-over-year basis, with median inflation moving to 4.6% from 4.9% and trim to 4.4% from 4.8%. All signs suggest that inflation is heading to 3% in the months ahead with most short-term metrics in the low-3% range.

Shelter inflation remains high with mortgage interest costs up 26.4% year-over-year, and up from 23.9% in February. With the cooling housing market, homeowners’ replacement costs are down to only 1.7% year-over-year, down from nearly 15% in late 2021. The Bank is likely to look through this component of inflation.

Goods inflation is decelerating faster than service inflation. Inflation for durable goods was down to 1.6% in March, as prices for furniture fell. Services inflation remained above 5% in March.

The Bank has made it clear they want to get to the 2% inflation target. Their credibility would be called into question if they said anything less. Is a policy rate of 4.5% sufficiently restrictive given these inflation trends? We expect the Bank will be patient in its approach. They are not likely to raise rates higher, but the overnight target rate will likely remain stuck at 4.5% until the end of the year as services inflation remains sticky. 


Independent Opinion

The views and opinions expressed in this publication are solely and independently those of the author and do not necessarily reflect the views and opinions of any person or organization in any way affiliated with the author including, without limitation, any current or past employers of the author. While reasonable effort was taken to ensure the information and analysis in this publication is accurate, it has been prepared solely for general informational purposes. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author. There are no warranties or representations being provided with respect to the accuracy and completeness of the content in this publication. Nothing in this publication should be construed as providing professional advice including investment advice on the matters discussed. The author does not assume any liability arising from any form of reliance on this publication. Readers are cautioned to always seek independent professional advice from a qualified professional before making any investment decisions.

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