Deputy Governor Paul Beaudry explains why the 2% target remains the centrepiece of the Bank of Canada’s inflation-targeting framework.
The benefits of being near the inflation target
Canadians know inflation is too high right now. But many may wonder why the Bank’s goal is to get inflation back to 2%.
Inflation is mostly influenced by the costs that go into what firms produce and sell. When inflation is high, firms tend to raise their prices more frequently. Consumers, in turn, expect higher prices and stop shopping around for the best deal.
But when a central bank has a credible record of achieving low and stable inflation, firms tend to absorb day-to-day changes in their costs rather than pass them on to consumers. This is because they believe inflation will stay close to the central bank’s target.
So, when inflation is near the target it tends to remain there, and prices are more stable. That helps the economy function better.
Returning to the 2% inflation target will bring back the stability Canada has known for the past 30 years, to the benefit of all Canadians.”
The dangers of straying from the target
For three decades, Canadians have benefited from the self-stabilizing effect of low and stable inflation. But the COVID‑19 pandemic and the rapid recovery that followed have changed that.
Inflation has gone from a topic few people think about to one that is top of mind for everyone.
Because people are more aware of inflation, they are more likely to look at recent price gains when deciding how much they expect costs to rise in the future. This can lead to high inflation that is more persistent, volatile and self-perpetuating.
High inflation, in turn, makes it harder for everyone to plan how to spend and invest. Companies may find it harder to make key decisions for growing their business when they don’t feel confident about where costs will be. This uncertainty leads to more ups and downs in the job market, which is bad for workers.
If inflation stays above target for a significant amount of time, then high and variable inflation will likely go hand in hand with a less efficient, more distorted economy.”
Not every path back to target will be the same
Canada is not alone facing high inflation. Countries we trade with may take a different path back to their own target. So what does that mean for Canadians?
To answer this, we need to look at Canada’s flexible exchange rate. The Bank does not determine the value of the Canadian dollar. Markets set the value based on the forces of supply and demand.
By letting the value of the dollar float based on supply and demand, the Bank has the flexibility to chart a path that is different from those of our trading partners.
If Canada manages to return inflation to target before our partners do, two outcomes are possible:
- The Canadian dollar does not strengthen against other currencies, making Canadian goods and services cheaper for foreign buyers. Exports get a boost, company profits grow and firms hire more workers to meet demand.
- The Canadian dollar rises in value, making Canadian exports more expensive for foreign buyers. This reduces demand for exports, but consumers and businesses benefit from a stronger dollar when buying foreign goods.
The bottom line is that we shouldn’t be too concerned if Canada follows a slightly different path to normalization than our counterparts. What matters most is getting all the way there.”