Guest post by Kevin English
Against the backdrop of the US Federal Reserve’s long exit from its program of quantitative easing, and a widely anticipated announcement from the European Central Bank (ECB) that it will become the first major central bank to introduce negative deposit rates, CIGI convened a timely session at the annual conference of the Canadian Economics Association (CEA). On the table was a discussion on the challenges confronting central bankers as they attempt to adapt previous best-practices to the new realities wrought by the past half decade’s historic financial upheaval.
Entitled “Critical Issues Facing Central Bankers: Independence, Remit, and Communications,” the session brought together a panel of expert researchers from the academic, policy, and private sector communities. Paul Jenkins, CIGI distinguished fellow and former senior deputy governor of the Bank of Canada, chaired panellists Ted Carmichael, former Chief Canadian Economist for JP Morgan and Founding Partner of Ted Carmichael Global Macro; Doug Laxton, of the International Monetary Fund’s (IMF) Research Department; Paul Beaudry, professor and Canada Research Chair at the Vancouver School of Economics at the University of British Columbia; and Pierre Siklos, associate professor of monetary economics at the Balsillie School of International Affairs and CIGI Senior Fellow.
This will be the first of a series of posts that summarize and analyze the issues raised during the 2014 CEA-CIGI session. In this first entry, I will take the opportunity to briefly summarize the dominant central banking policy framework on the eve of the global financial crisis: inflation targeting (IT). Reviewing the “nuts and bolts” will hopefully serve as a good jumping off point for the posts that follow.
In one of the his last major speeches before departing the Bank of Canada in 2013, Governor Mark Carney[1] outlined what he viewed as the four main components of an IT framework. These are: i) a clear objective (usually price stability, defined as tolerable range of inflation outcomes and a central target level); ii) an independent central bank to pursue this objective; iii) a single instrument (usually a very short-term interest rate); and iv) transparent communication.
Typically an IT central bank will vary its short-term rate to align with a macroeconomic forecast that shows the bank achieving its objective over the medium-term (typically 6-8 quarters). The reasons for the policy rate decision (i.e. why it is needed to achieve the Bank’s stated objective), the bias of the decision[2], and the forecast itself are usually clearly communicated to the public.
It is this final component, the premium placed on transparent communication, which helps differentiate IT from previous dominate policy frameworks. It is also critical to both its success and to the accountability of monetary policy. Accountability in turn, reinforces independence. As Governor Carney stressed:
“The clarity of the inflation target allows households and firms to make longer-term plans with greater confidence, aligning their savings, investment and spending decisions with a common inflation-control objective, with these actions collectively serving to make the inflation target self-reinforcing. Transparent communications that illuminate how the central bank responds to the forces at work on the economy help markets and the public form and evolve their expectations efficiently, which further aids the achievement of the inflation objective.”
The clarity of central bank communication, paired with a long track record of achieving its inflation control objective and a well-defined degree of independence, is what has (arguably) helped anchor inflation expectations over the past two decades. This anchoring of expectations, in turn, provided central banks with breathing room to respond aggressively to the financial crisis. Note, for example, that despite a quintupling of the Federal Reserve’s[3] balance sheet since 2008, inflation expectations in the US have remained firmly anchored around 2 percent.
Critical to the discussion at the 2014 CIGI-CEA panel, it is worth noting that nowhere in Carney’s definition of pre-crisis IT, is financial stability stated as an explicit and separate objective of monetary policy.
In next post in this series, we will discuss Ted Carmichael’s presentation, which explains how the Bank of Canada arrived at an IT framework and challenges it faced in adapting the framework to the brave new post-crisis world.
Kevin English is a research associate with CIGI's Global Economy Program.
[2] The “bias” of a rate decision usually refers to whether the central bank anticipates a tightening or loosening of policy as the most likely outcome of the next policy decision.
[3] The Federal Reserve is not considered technically an inflation targeting central bank. However, its policy framework shares many of the same components identified by Governor Carney. For example, the central bank is widely believed to be a forefront of transparency and communication strategies.