The consumer price index (CPI) is the most commonly used measure to track changes in the overall level of prices. Since it departs from a true cost-of-living index, the CPI is subject to four types of measurement bias—commodity substitution, outlet substitution, new goods and quality adjustment. The author updates previous Bank of Canada estimates of measurement bias in the Canadian CPI by examining these four sources of potential bias. He finds the total measurement bias over the 2005–11 period to be about 0.5 percentage point per year, consistent with the Bank’s earlier findings. Slightly more than half of this bias is caused by the fixed nature of the CPI basket of goods and services.
Topics: Inflation and prices; Inflation targetsIn the years since the 2006 renewal of Canada’s inflation-control agreement, monetary policy regimes have faced significant shocks, including the global economic and financial crisis. This article reviews the recent experience with inflation targeting, including the debate about the appropriate role of monetary policy in maintaining financial stability. In the aftermath of the crisis, both the United States and Japan adopted numerical inflation objectives. Overall, a flexible inflation-targeting framework, supported by central bank independence, accountability and clear communications, remains a robust monetary policy regime for promoting economic welfare.
Topics: Credibility; Financial stability; Inflation targets; Monetary policy frameworkThe recent financial crisis and global economic slowdown have renewed interest in monetary policy options when the policy interest rate is at or near zero. This article examines how different monetary policy frameworks might help to lower the risk and economic cost of such a scenario. The authors present an analytical framework for examining monetary policy at the zero bound, particularly the role of inflation expectations in lowering the real interest rate. The influence of inflation targeting on inflation expectations and how forward guidance or a conditional commitment to future monetary policy may augment traditional monetary policy actions are also examined. The authors then examine recent research on the efficacy of price-level targeting (PLT) at the zero bound, which demonstrates that a credible PLT framework can reduce the likelihood of hitting the zero bound and lessen the economic costs of remaining there. PLT is also found to offer stabilization advantages in "normal" times, although these hinge critically on the degree of credibility of the PLT regime.
Topics: Inflation targets; Monetary policy frameworkStephen Murchison reviews the findings of recent Bank of Canada research on the relative merits of inflation targeting and price-level targeting (PLT) for a small open economy, such as Canada's, that is susceptible to large and persistent terms-of-trade shocks. These shocks have been identified as a potential threat to PLT, since central bankers have to induce large fluctuations in output if they are to unwind all pass-through to the price level. The balance of evidence suggests that PLT and inflation targeting, implemented through simple policy rules, are fairly similar in their ability to stabilize inflation, the output gap, and interest rates. The author shows that this conclusion is robust to the inclusion of several types of relative-price shocks, including shocks to the terms of trade. Research on the optimal price index under PLT is also discussed, and Murchison concludes that, conditional on adopting PLT, the overall CPI would represent close to an ideal index to target.
Topics: Central bank research; Inflation targets; Monetary policy frameworkAlthough the current inflation-targeting regime has served Canadians well, sound public policy demands the continuous exploration of possible improvements in the monetary policy framework. At the Bank of Canada's 2009 conference, distinguished scholars from academic institutions and monetary authorities around the world discussed two central questions regarding the design of monetary policy: (i) Would an inflation target lower than 2 per cent lead to better economic outcomes? And (ii) What are the costs and benefits of price-level targeting relative to inflation targeting? The conference agenda included work that shed new light on these two questions. Other work explored the causes of zero-bound episodes and the efficacy of potential policies.
Topics: Central bank research; Inflation targets; Monetary policy frameworkInflation-targeting central banks around the world often state their inflation objectives with regard to the consumer price index (CPI). Yet the literature on optimal monetary policy based on models with nominal rigidities and more than one sector suggests that CPI inflation is not always the best choice from a social welfare perspective.
Topics: Inflation and prices; Inflation targets; Inflation: costs and benefits; Monetary policy framework; Monetary policy implementationThis article explores the role of inflation expectations in the conduct of monetary policy. It reviews the various measures of inflation expectations used by central banks, including surveys and market-based indicators, and considers their advantages and disadvantages. It examines the critical role of inflation expectations in the framework that central banks use to understand, forecast, and control inflation. It also looks at their role as an indicator of central bank credibility. The behaviour of inflation expectations over the past two years is analyzed and policy conclusions are offered.
Topics: Inflation targets; Monetary policy implementationThis paper uses a small-open economy model for the Canadian economy to examine the optimal Taylor-type monetary policy rule that stabilizes output and inflation in an environment where endogenous boom-bust cycles in house prices can occur.
Topics: Credit and credit aggregates; Financial stability; Inflation targetsThis paper introduces heterogeneous beliefs among households in a small open economy model for the Canadian economy. The model suggests that simultaneous boom-bust cycles in house prices, output, investment, consumption and hours worked emerge when credit-constrained mortgage borrowers expect that future house prices will rise and this expectation is neither shared by savers nor realized ex-post.
Topics: Credit and credit aggregates; Financial stability; Inflation targetsIn 2006, the Bank initiated a research program exploring two alternatives to the current inflation-targeting framework: (i) lowering the inflation target and (ii) shifting to a price-level target. This article discusses progress to date, places the Bank's findings in the context of a broader literature, and identifies avenues for future research. Earlier literature and recent studies at the Bank suggest that an inflation target below two per cent is likely preferable to the status quo, though it is unclear how much lower policy-makers should aim and also how much Canadians would benefit from a shift. With regard to the price-level target, evidence is more mixed, with need for study concerning (i) the target's influence on contracting behaviour and inflation expectations; (ii) strategies for ensuring credibility in the commitment to price-level targeting; and (iii) the Canadian economy's vulnerability to shocks that the literature identifies as particularly detrimental to the target's performance.
Topics: Central bank research; Economic models; Inflation and prices; Inflation targets; Inflation: costs and benefits; Monetary policy frameworkMany central banks around the world have embraced inflation targeting as a monetary policy framework. Interest is growing, however, in price-level targeting as an alternative. The choice of frameworks has important consequences for financial contracts, most of which are not fully indexed to the price level. Changes in the price level therefore lead to changes in the real value of contracts. Price-level targeting would reduce the size of these changes in real wealth and decrease uncertainty about the future price level. This article assesses the merits of price-level targeting vis-à-vis inflation targeting from a debt-revaluation perspective, with a focus on channels affecting risk premiums, the maturities of nominal debt contracts, and redistribution of wealth. A general conclusion flowing from the analysis is that accounting for the revaluation of nominal debts and assets strengthens the relative merits of price-level targeting compared with inflation-targeting.
Topics: Inflation targets; Inflation: costs and benefits; Monetary policy frameworkAlthough the concept of monetary policy lag has historical roots deep in the monetary economics literature, relatively little attention has been paid to the idea. In this paper, we build on Svensson's (1997) inflation targeting framework by explicitly taking into account the lagged effect of monetary policy and characterize the optimal monetary policy reaction function both in the absence and in the presence of the zero lower bound on the nominal interest rate.
Topics: Inflation targets; Monetary policy framework; Monetary policy implementationCentral bankers from inflation-targeting and non-inflation-targeting countries around the world and several distinguished scholars assembled at the Bank of Canada in July 2008 to review the international experience in some detail. This article highlights topics covered in the special lectures and sessions, including how inflation targeting can manage external shocks, various ways in which monetary policy decisions are taken, and the issues of transparency and communications. It also reports on the discussion in the closing panel, which considered options for the future of inflation targeting.
Topics: Central bank research; Inflation targets; Monetary policy frameworkSince the work of Doepke and Schneider (2006a) and Meh and Terajima (2008), we know that inflation causes major redistribution of wealth – between households and the government, between nationals and foreigners, and between households within the same country.
Topics: Economic models; Inflation and prices; Inflation targets; Inflation: costs and benefits; Monetary policy framework; Sectoral balance sheetThis paper compares price-level-path targeting (PT) with inflation targeting (IT) in a sticky-price, dynamic, general equilibrium model augmented with imperfections in both the debt and equity markets. Using a Bayesian approach, we estimate this model for the Canadian economy. We show that the model with both debt and equity market imperfections fits the data better [...]
Topics: Economic models; Inflation targets; Monetary policy frameworkThere is currently a policy debate on potential refinements to monetary policy regimes in countries with low and stable inflation such as the U.S. and Canada. For example, in Canada, a systematic review of the current inflation targeting framework is underway.
Topics: Inflation and prices; Inflation targets; Inflation: costs and benefits; Monetary policy framework; Sectoral balance sheetGosselin examines and reports on the various factors that contribute to successful inflation targeting. Using a panel of 21 inflation-targeting countries over the period 1990Q1-2007Q2, Gosselin finds that the ability of central banks to hit their targets varies considerably. Some of these differences can be explained by exchange rate fluctuations, fiscal deficits, and differences in financial development. Others are explained by differences in the targeting framework itself and the manner in which it is implemented.
Topics: Central bank research; Inflation targets; Monetary policy frameworkThe authors analyze the extent to which inflation-targeting frameworks should incorporate flexibility in order to respond to asset-price misalignments and other atypical events. They examine the costs and benefits of adding flexibility to the Bank's current inflation-targeting framework, and conclude that maintaining low and stable consumer price inflation is the best contribution that monetary policy [...]
Topics: Inflation targets; Monetary policy frameworkThe authors investigate the implications of house-price bubbles for the optimal inflation-target horizon using a dynamic general-equilibrium model with credit frictions, house-price bubbles, and small open-economy features. They find that, given the distribution of shocks and inflation persistence over the past 25 years, the optimal target horizon for Canada tends to be at the lower [...]
Topics: Central bank research; Credit and credit aggregates; Economic models; Inflation targets; Monetary policy framework; Transmission of monetary policyHow do firms adjust prices in the marketplace? Do they tend to adjust prices infrequently in response to changes in market conditions? If so, why? These remain key questions in macroeconomics, particularly for central banks that work to keep inflation low and stable.
Topics: Inflation targets; Transmission of monetary policyThe inflation targeting (IT) regime is 17 years old. With practice of IT now in more than 21 countries, there is enough evidence gathered to take stock of the IT experience. In this paper, we analyze the inflation record of IT central banks.
Topics: Central bank research; Inflation targets; Monetary policy frameworkSurveys provide direct information on expectations, but only short histories are available at quarterly frequencies or for long-horizon expectations.
Topics: Inflation and prices; Inflation targets; Uncertainty and monetary policyThe authors study the macroeconomic effects of non-zero trend inflation in a simple dynamic stochastic general-equilibrium model with sticky prices.
Topics: Business fluctuations and cycles; Economic models; Inflation and prices; Inflation targetsBeginning with a review of the adoption of inflation targeting in a broad group of countries, Paulin focuses on changes in the design of inflation-targeting frameworks in light of fifteen years of accumulated experience. Included in the discussion are the use of numerical targets and ranges, the policy horizon, supporting institutional policy structures, and communication, including the publication of forecasts. A recurring theme is how much flexibility an inflation-targeting regime allows. The article concludes that the changes made to the frameworks have been relatively modest since their adoption, but in concert with the improved credibility that has resulted from central banks meeting their inflation-control targets, they have allowed an increasingly nuanced response to economic shocks.
Topics: Credibility; Inflation targets; Monetary policy frameworkSince the Bank of Canada adopted inflation targeting in 1991, it has focused on a measure of core inflation as a shorter-term guide for monetary policy. When the targets were renewed in 2001, the Bank adopted CPIX as its measure of core inflation because of the advantages it offered. Leflèche and Armour review the experience with CPIX and whether the criteria used to select it in 2001 still favour the measure today. They describe the various measures of core inflation monitored by the Bank and evaluate them on the basis of the volatility of the components, the volatility of the core measures themselves, absence of bias relative to total CPI, predictive power, and certain practical criteria, including timeliness and credibility. They conclude that CPIX still satisfies all the empirical and practical criteria.
Topics: Inflation and prices; Inflation targets; Monetary policy framework
