The spectre of continued weak inflation haunts central bankers. In a recent speech, Governor Stephen Poloz of the Bank of Canada suggests that the absence of inflation has led “some to question whether central banks can still target inflation effectively.” Poloz adopts a very defensive posture and argues that Bank of Canada does understand the “inflation process and retains the ability to guide inflation to our targets over time.”[1]

Here are some of the factors that the Governor says has kept the inflation rate well below target:

• Exchange rate fluctuations; the rising Canadian dollar reduces the costs of imports;
• Fluctuations in global commodity prices, especially oil, play havoc with consumer prices;
• Special one-time changes in selective domestic products and services, e.g. in the U.S. a drop in the price of mobile phone packages; and, in Canada, a drop in Ontario’s electricity prices:
• Externally, global supply chains have held down inflation, independently of any domestic supply-demand balance;
• Disruptive technologies, such as Uber, Airbnb and, most significantly the so-called Amazon effect on retail prices; and,
• The breakdown in the Phillips curve, the relationship between wages and unemployment rates; despite record low unemployment rates, wage growth has stagnated; many reasons for this breakdown can be found in the changes in the nature of work and in the composition of the labor market.

Ironically, with the exception of fluctuations in the exchange rate, monetary policy has no real impact on any of these factors cited by the Governor.  Each in its own way works through the economy and is essentially immune to changes in interest rates or liquidity in the banking system.

Yet, the Governor Poloz defends inflation targeting arguing that:

In the absence of shocks coming from external factors, we can expect the trend of inflation to be sustainably around the midpoint of the target range when the economy is operating at full capacity and inflation expectations are well anchored on the target. That is why I have said that “home” for the economy is at the intersection of full capacity and 2 per cent inflation.

So, the Bank of Canada is sticking to its guns, despite evidence to the contrary that deflationary forces are operating against it. They continue to expect that as the economy moves closer to full utilization, the greater the risk that inflation will appear. Poloz doubles down on his argument by stating that it is “premature to conclude that there is something amiss in the traditional inflation process”.  

Maybe it is the right time to re-think these inflation targets which have been so elusive this past decade. As Keynes said when challenged by a critic on his abrupt change in investment tactics “when the facts change, I change my mind-- what do you do, sir?”

[1] Understanding Inflation: Getting Back to Basics, November 7, 2017