Thank you.
It's a real pleasure to have an opportunity to chat with you about this terribly important subject.
The goal of monetary policy is ultimately the management and supply of money and the level of interest rates in a manner that supports economic growth and the highest possible standard of living. That's what we want to do. From the point of view of highest possible standard of living, this also means that you really want to have as close to full employment as you can.
I would argue that the central mandate of the Bank of Canada already encompasses a multi-dimensional approach to the ideal environment they are hoping to achieve. We need to understand that they are only one part of the bigger economic system, and they have limited impacts.
As to how to achieve this goal, there are various options. Let's be honest: all the options have pros and cons, and no one approach is perfect. So what's the mandate that we've had and what's the mandate that's just been renewed? Since 1991 the Bank of Canada has been targeting inflation. Since the end of 1993, it's been the 2% midpoint target of the 1% to 3% range.
Economic theory tells us that in the short run monetary policy can have a big impact on the economy. We can see the effect of lowering interest rates in early 2009 and the impact this had on the housing market in Canada, helping to boost domestic demand and mitigate the recession.
Over the very long run, the impact of monetary policy is primarily on the level of prices. If you're going to create a low and stable inflation environment over the long run, over several business cycles, you should see evidence that it will lead to the economy growing at around its long-term trend, with lower and more stable unemployment.
What's the evidence? Well, over the last two decades we've seen inflation average almost exactly 2%, so the Bank of Canada has to be commended for hitting their target almost perfectly over a two-decade period.
Then you look at economic growth. Economic growth has been 3%. Most economic estimates would say that 3% through the 1990s was probably the potential rate of growth, the long-term trend in the rate of growth. Right now I think the trend rate of growth in Canada has slowed, so we'll be lucky if we actually get 3% on a sustained basis going forward. That's not a reflection of monetary policy; that's a reflection of demographics and productivity. The Bank of Canada does not have control over productivity. They can help encourage investment by having interest rates lower. They can lead the horse to water, but they can't make it drink.
We've seen that we have had periods of low unemployment in Canada. We reached a point where unemployment was at a three-decade level. In fact, it was creating problems for parts of the economy. The reason we had higher unemployment in recent years had to do with an external shock to the Canadian economy. It had nothing to do with the domestic economy, and that's what domestic economic policy can affect.
I would argue that the existing mandate has served the country very well. Could we change the target? Yes, we could lower it. If we lowered it, you'd start running into challenges of measurement. When you start getting down to around 1%, people start to worry about deflation, so maybe 1% is a little too low. If you raise it, I'm not sure why you'd want to reduce the purchasing power of people's money over the long haul at a faster rate. So 2% seems like a very reasonable target.
The next question is, would an alternative model serve us better? The last model has been doing a good job. Should we adopt something different? I think it's a very reasonable and healthy thing to have the mandate renewed periodically and to have discussions like this about what the appropriate mandate should be. When I think about all the other options and the current target, I'm reminded of the quote by Winston Churchill that democracy is the worst political system except all the rest.
Regarding the inflation-targeting environment, I think there are lots of other options. You can have a lot of complaints about the 2% target, but it's probably the best among all the other options. We could target full employment, except that we don't actually know where full employment is. Estimates are somewhere between 6% and 8%. And I don't think it's useful to have a target that you can't pinpoint.
I would contend that actually the unemployment rate is in the decision-making function of the Bank of Canada, because when it is setting monetary policy it does consider a large number of other variables. One of the core variables it looks at is the amount of slack in the economy and the output gap, and that is largely a function of what's happening in the labour markets. The Bank of Canada does implicitly build unemployment into its thinking about where monetary policy should be headed without its being the explicit target of the inflation rate.
Regarding nominal GDP targeting, I've got to be honest that I actually think there's a compelling argument for the U.S. Federal Reserve to have a nominal GDP target. I don't actually think it's appropriate for Canada. I think the main issue here is that the U.S. economy is currently in a liquidity trap, where low interest rates are not going to propel stronger economic growth or above-trend economic growth, but this is an exceptional situation. I'm not convinced you should actually adopt an exceptional policy that's appropriate for another country as the business-as-usual target for Canadian monetary policy.
I think there are a lot of reasons that nominal GDP targeting would be effective in the United States. I'm not sure that we should adopt it here, for many of the reasons Chris outlined, because at the end of the day, I don't think we are indifferent between targeting 4.5% nominal GDP growth and 4.5% inflation and zero real growth.... I'm not indifferent between that and 0% inflation and 4.5% real economic growth. So it's a functional challenge.
I think there is a lot of merit to price-level targeting, and this something the Bank of Canada is very enamoured with. My main problem with it is a communication issue, and that is that if you end up with inflation at 1% for an extended period of time, you probably should run 3% over a period of time to get you back to 2%. The problem is that when you get to 3%, if it's sustained for a length of time, you're going to get the media and markets worrying that 3% isn't the peak, and it could lead to un-anchor inflation expectations.
Lastly, in terms of dual mandates, I think if you have one target it's a very simple way of characterizing what the bank is doing. If you have dual targets, I think you take your eye off the ball, and that runs the risk of creating an inflation problem.