Quiz 3 Flashcards
Inflation Targeting time periods
- Initial tagreting framework coverd period from 1991- 1995
- Extended at the end of 1995- 1998 then again 1998-2001
- Renewed every 5 years since 2001
What happens in Inflation targeting framework reviews
- consultation with the public and academics to determine how well this framework has performed.
- consider other alternatives
Components of the agreement
(1) Broad objectives of monetary policy
(2) The inflation-control target
(3) Flexibility or Flexible Inflation Targeting (FIT)
(4) Important qualifications or other considerations
Broad objectives of monetary policy
- The best thing monetary policy can do for national well-being is to pursue price stability (initially proposed by Freidman)
- Monetary policy should support maximum sustainable employment; that is, aim to stabilize the economy around potential output and the inflation target. Consistent with the natural rate hypothesis.
- While employment/output considerations are important, anchored inflation expectations are critical to achieving low inflation (the inflation target) over time. Also consistent with the natural rate hypothesis.
The inflation-control target
The specific details of the inflation-control target:
- The target will continue to be defined in terms of the 12-month rate of change in the total CPI
- the inflation target will continue to be the 2 percent mid-point of the 1 to 3 percent inflation control range
Specific measure for inflation in the framework
- Uses Core inflation as a guide for policy.
- Core measures are now maintained by Statistics Canada
Total CPI
- Transparent, understandable and independent of the Bank
- a noisy measure of underlying price pressure
Three core measures
- CPI-Trim
- CPI-Median, and
- CPI-Common- provided a poor guide during the pandemic and has been removed from policy analysis
Flexibility
- The control range of 1–3 % provides the Bank with some flexibility (what it means operationally is not always clear)
- Not specified in the Agreement, the target is symmetric. (Emphasized in the summary of the inflation-control strategy at the start of the MPRs)
- 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)
-By taking more time, it can be less aggressive with monetary policy (raising or lowering interest rates).
The main concern about the return to the target
- The effects on economic activity, which is now made operational (to some extent) by the emphasis on the level of maximum sustainable employment
- Other concerns may include household or firm balance sheets and the effects of monetary policy focused solely on inflation.
MSE in Inflation targeting framework
- Maximum Sustainable employment ( new in 2021)
- We don’t know what the MSE is, and its hard to measure
Two specific references to where flexibility might be needed
(1) low-for-longer because of the effective lower bound (ELB)
(2) probing for the MSE.
An example of flexibility as low-for-longer
- Low global interest rates will mean that negative shocks to the economy will mean the Bank is at the ELB often. That is, the economy will experience periods of low inflation, low economic activity, and interest rates at the ELB
- Since monetary policy is constrained by the ELB, it is difficult for monetary policy to quickly get inflation back to target.
- Economic modelling suggests that a commitment to low interest rates (forward guidance), along with quantitative easing, can lead to a more rapid return to target for inflation and full employment.
- But this comes with the risk of overshooting the inflation target because the low-for-longer approach means that monetary policy will likely only begin to contract after inflationary pressures have started to build.
- This risk is, within limits, acceptable as it is consistent with flexibility in the inflation target.
- Perhaps this explains in part what happened in 2020–21, though obviously inflation has gone well past the 1–3 percent control range.
An example of flexibility as probing for the MSE
Monetary policy decisions (e.g., raising or lowering interest rates) are based on projections of inflation (π), output (y) and potential (maximum sustainable employment) output (y ̄).
* Projections are made for the policy horizon (e.g., two years). Projections are written as {π}, for example, which means inflation over the policy horizon.
* Suppose that the Bank is faced with a path of inflation based on a low estimate of the potential level of output (our proxy for the MSE). This is shown as inflation is expected to reach 3% over the policy horizon and would normally require tighter monetary policy. Potential output is y ̄low
* Suppose, though, that potential output is higher, y ̄high. In this case, inflation is not projected to reach 3% and no change in monetary policy is warranted.
Why: the bigger the projected output gap, the more inflationary pressure.
* Probing would have the central bank not raise interest rates and see how things proceed. If inflation does not rise as quickly as the upper projection, this might be consistent with the higher potential output.
* If the Bank is wrong, then it will see inflation at or around 3% but this mistake is consistent with the flexibility of the 1–3 percent inflation-control range.
Important Qualifications
MOST IMPORTANT - flexibility has to come second to maintaining anchored inflation expectations:
The Bank will utilize the flexibility of the 1 to 3 percent range only to an extent that is consistent with keeping medium-term inflation expectations well anchored at 2 percent
Two of these are about communication and a broader outlook:
- When the Bank is exercising flexibility, it is expected to explain this: The Bank will explain when it is using the flexibility in the framework.
- The Bank will consider and report on more information about the labour market with respect to policy than it has in the past: The Bank will consider a broad range of labour market indicators and will systematically report to Canadians on how labour market outcomes have factored into its monetary policy decisions.
A further qualification
- addresses the difference between the average
inflation targeting and flexibility. Flexibility does not mean that if inflation is below target for a period of time it is intentionally to be averaged out by a period of above target. Rather, ’bygones are bygones’.
