Why we target 2% inflation

Inflation measures the rate of growth in prices, and the Bank of Canada aims to keep it at 2%. When inflation is low, stable and predictable, the entire economy works better.  

What is the 2% inflation-control target?

The Bank has an inflation-control target of 2%—the mid-point of a 1%–3% range. To keep inflation at or around 2%, we adjust our policy interest rate. Increasing the policy rate slows the economy and brings inflation down when it is too high above the target. Decreasing our policy rate heats up the economy and brings inflation up when it is too far below the target.

We adopted the inflation-control target in 1991. Since then, inflation, as measured by the consumer price index, has been at or around the 2% target most of the time. In the early 2020s, inflation did rise well above the target, peaking at 8.1% in June 2022. But we responded by raising our policy interest rate and brought inflation back to 2%. Before we adopted the inflation-control target, inflation was much more unpredictable. In the 25 years leading up to 1991, inflation averaged more than 6%.

Our economy works with 2% inflation

When inflation is at or around 2%, the entire economy works better. Prices go up a little bit each year, but the increases are small enough that most people adjust without any problem. The 2% inflation control target is ideal because it avoids the problems associated with high inflation, such as economic uncertainty and the erosion of purchasing power. But it also helps avoid declining prices. When inflation falls below zero, it is called deflation, and it can lead to economic downturns and job losses. Setting the inflation control target below 2% would bring inflation very near to zero, increasing the risk of deflation.

Setting a clear target encourages people to plan for that target. We have had a 2% inflation target for decades and we have achieved it. The 2% target supports economic growth because it gives consumers and businesses the confidence they need to borrow, invest, save or spend. A clear goal of 2% inflation is easy for everyone to understand, and we can aim for this goal with monetary policy actions like adjusting our policy interest rate. Having a target holds central banks accountable, and achieving it shows that monetary policy is working.

How we came to inflation targeting

In 1991, the Bank of Canada became one of the first central banks to adopt an inflation target. Since then, many other advanced economies have adopted similar targets. But even before inflation targets were used, central banks tried to control inflation. However, the most widely used approaches had some significant flaws and did not deliver price stability.

• Government-imposed wage and price controls restrict how much wages and prices can increase. These measures keep prices down but don’t address the underlying causes of inflation. So, when they are removed, inflation increases again.
• Money-growth targeting limits the growth of the money supply, and central banks tried this to control inflation. Between 1975 and 1981, the Bank set targets for physical currency in circulation and the total amount of deposits held in chequing accounts. This successfully limited the growth of the money supply, but inflation continued to rise.
• Fixing the exchange rate pegs the value of one country’s currency to the value of another country’s currency. But this works to control inflation only if the other country successfully controls inflation.  

How we set the inflation control target

Every five years, the Bank reviews and renews our monetary policy framework with the federal government. The review gives us the opportunity to assess how well the inflation control target is working and evaluate whether it is still the best approach to monetary policy.

We live in a world in which:

• Our economy is more vulnerable to economic volatility.
• Supply shocks are becoming more frequent.
• Housing supply has not kept up with demand and housing affordability has deteriorated.

We consider factors like these during the review process, as well as whether there are additional tools that could help us navigate changes in how the economy is working.

Every time we have reviewed our monetary policy framework, we have concluded that a 2% inflation target is right for Canada. In the decades since we adopted the inflation-control target, it has performed well in both good economic times and bad. When we set a clear target, individual Canadians and businesses know what our goals are and what we will do to achieve them. This clarity gives people confidence in price stability, which encourages sound financial decision-making that benefits the entire economy.