Thank you, sir, and committee members. I am very grateful for the invitation to participate in this discussion.
I see that the government announced last week that the target is going to be extended for five years. I'm not sure how we'll fit into that decision process, but I think these issues of inflation targeting and monetary policy are among the most important economic issues facing the country, and I'm very honoured to participate in this discussion.
In my judgment, the economic and financial events of the last three or four years should lead us to fundamentally question both the theory and the practice of inflation targeting. The theory of inflation targeting goes as follows. There's assumed to be some kind of automatic tendency for the real economy to settle at some kind of a full employment equilibrium position, often defined as a NAIRU, non-accelerating inflation rate of unemployment. Monetary policy is seen to have no long-run impact on that real equilibrium. The best thing monetary policy can do, the theory goes, is to promote stability in prices and therefore greater certainty and better judgments by the participants in that real economy.
That underlying faith in the self-adjusting character of the real economy was never, I would say, justified. After the events of the last three or four years and especially facing a horizon of several years of difficult times to come, that underlying faith seems downright bizarre. Clearly, private markets are not necessarily efficient. The market economies do not automatically adjust to recreate full employment. They can become stuck for long periods of time in positions that are suboptimal, underutilized, and socially damaging.
While the inflation targeting regime in Canada is clearly temporally associated with lower inflation and more stable inflation, as the Bank of Canada's backgrounder makes clear, its success depends on the impact of inflation stability on the real economy. I will also point out that the disinflation and the lower and more stable inflation rates that were observed in Canada are also observed in many countries that did not adopt inflation targeting.
At any rate, the ultimate end goal of economic activity is not low and stable inflation. The ultimate end goal is maximum employment, productivity, and output. Has inflation targeting boosted these goals or not? The data contained in the Bank of Canada's background document, their own data, suggests that's not at all clear. Their table 1 shows that average real GDP growth has in fact been slower under inflation targeting than under the previous regime. The average official unemployment rate has hardly changed. Real long-run interest rates have not fallen at all. The table doesn't note it, but productivity growth in Canada has slowed notably under this regime. So the real economic benefits of low and stable inflation are hard to find, but I think we've become more aware in the last couple of years of some of the costs of getting to and maintaining a near-zero inflation target.
Very low inflation rates make it hard to facilitate relative price adjustments, including adjustments in the relative price of labour. Those relative price adjustments may require nominal price reductions, which are always difficult.
Very low inflation rates impose a binding floor to the operation of monetary policy, because interest rates can't fall below zero. Therefore in a 2% target world, real interest rates cannot fall below negative two. But in moments of crisis, you may want your real interest rates to be much lower than that.
Very low inflation rates increase the risk of deflation, because there's not much of a cushion before you tip over into negative inflation, which can cause all kinds of dangerous and explosive results on debt burdens and spending decisions.
Very low inflation enhances the real burden of debts on consumers and governments, and reduces real tax burdens, neither of which are desirable in the current context.
In light of these issues, there's a view among a growing number of economists that the optimal level of inflation is not 2% and it should be possibly higher, perhaps 4% or 5%.
My own conclusion is different. I find a flaw in the fundamental logic of inflation targeting. There are times when proactive monetary policy is necessary to be targeting particularly employment growth, increasing output, and helping the economy out of recession or even depression. An inflation target unnecessarily ties the hands of monetary policy in doing that.
I recognize fully that the practice of monetary policy in recent years at the Bank of Canada has been more flexible than the inflation target alone would make it look. I applaud that flexibility, which has been important in the current crisis. To some extent, I think we're maintaining a polite fiction, that the Bank of Canada is concerned with one thing and one thing only, namely inflation. In practice, they've been concerned about many things, and they've behaved accordingly.
Why don't we just acknowledge that the Bank of Canada faces a difficult but essential task of balancing different goals? The pre-eminent goal should be the maximization of output and employment to foster long-term sustainable productivity growth. That goal has to be pursued within the constraints of other issues, such as sustainable inflation, sustainable external balances for the country, and sustainable social and environmental performance.
The ultimate goal is real output and employment. The Bank of Canada should be given a diverse and flexible mandate that allows that pre-eminence to be respected.
Thank you.