## Strengthening Canada's Economic Toolkit: Improving the Inflation Targeting Framework _IMF Blog, November 1, 2016_ ## Source details **Canonical URL:** [Strengthening Canada's Economic Toolkit: Improving the Inflation Targeting Framework](https://www.imf.org/en/blogs/articles/2016/11/01/strengthening-canadas-economic-toolkit-improving-the-inflation-targeting-framework) ## Other formats - [Markdown version](/en/blogs/articles/2016/11/01/strengthening-canadas-economic-toolkit-improving-the-inflation-targeting-framework/index.md) - [Structured JSON version](/en/blogs/articles/2016/11/01/strengthening-canadas-economic-toolkit-improving-the-inflation-targeting-framework/index.json) - [Bundle manifest](/en/blogs/articles/2016/11/01/strengthening-canadas-economic-toolkit-improving-the-inflation-targeting-framework/bundle-manifest.json) ## Bibliographic details - Authors: Maurice Obstfeld, Douglas Laxton, Yulia Ustyugova, Hou Wang - Published: November 1, 2016 --- ### Background and recent performance - For the past 25 years, Canada’s monetary policy framework has been working well. - Headline inflation averaged 1.9 percent, 1994–2015. - Long-term inflation expectations have been very well anchored to the 2 percent target. - Authors: Maurice Obstfeld, Douglas Laxton, Yulia Ustyugova, Hou Wang. - Date: November 1, 2016. ### Current challenges to monetary policy - Unusual global and domestic conditions: low and sub-zero interest rates; significant economic slack; risk that inflation might get stuck below target. - Central bank unconventional tools under consideration include ad hoc forward guidance on the policy interest rate, quantitative easing, funding for credit, and negative interest rates. - Such unconventional tools have disadvantages and communications risks. ### Recommendation: Use conventional forward guidance before unconventional tools - Systematic transparency about policy intentions increases monetary policy effectiveness. - Recommendation: The Bank of Canada should publish the path of the short-term interest rate from the forecast used at its policy meetings. - The Bank holds 8 per year policy meetings. - Guidance should be conventional (routine publication) and include usual caveats: not a commitment and conditional on the Bank’s latest forecast. - Publication of a confidence band for the interest rate path, and alternative scenarios to the baseline forecast, is recommended to clarify conditionality. ### Distinction: conventional forward guidance vs. ad hoc forward guidance - Conventional forward guidance: routine publication of the forecast policy-rate path tied to the Bank’s conditional forecast. - Ad hoc forward guidance: a conditional commitment to a very low rate used in past episodes (Bank of Canada in 2009; more extensively by the U.S. Federal Reserve and the Bank of England). - Ad hoc guidance reduced longer-term interest rates but created communications problems about commitment duration and subsequent policy moves. ### Rationale: how conventional forward guidance strengthens policy - Point 1: The current money market overnight interest rate has negligible direct macroeconomic effect by itself; effectiveness depends on influence over expected future short-term rates and medium- and longer-term interest rates faced by households and firms. - Policymakers therefore need a view on the whole medium-term path of the policy rate when making decisions. - Point 2: The policy rate path that returns inflation to target is not unique; the chosen path reflects policymakers’ preferences about the short-run output and inflation trade-off. - Only the central bank knows the intended path; without direct guidance, markets must guess intentions. - Publishing the forecast interest rate path reveals how the central bank plans to navigate the output/inflation trade-off. - If credible, this will move the term structure of interest rates and the exchange rate in support of policy objectives. ### Policy scenario: using conventional forward guidance to avoid a low-inflation trap - Risk: Further negative shocks when the policy interest rate is near zero could push the economy toward a low inflation trap that is hard to escape. - Proposed strategy under conventional forward guidance: - Explicit forecast for the policy rate to stay low for longer. - Allow inflation to temporarily overshoot the target to raise inflation expectations, lower real interest rates, depreciate the exchange rate, and stimulate the economy. - As economic growth improves, raise the desired interest rate and exit from ultra-low interest rates safely. - Conventional forward guidance enables the central bank to give a credible public account of this strategy and reinforce confidence in the 2 percent inflation target. ### Interaction with fiscal policy - Current fiscal stimulus in light of Canada’s economic challenges is fully justified. - Rationale: low government debt-to-GDP ratio and the exceptionally low cost of long-term government borrowing. - Making monetary policy instruments more effective would complement fiscal efforts to boost growth, strengthening Canada’s resilience and ability to handle unexpected shocks. *Source: Strengthening Canada's Economic Toolkit: Improving the Inflation Targeting Framework (Maurice Obstfeld, Douglas Laxton, Yulia Ustyugova, Hou Wang), November 1, 2016.* --- ## Content in this bundle - **How to Improve Inflation Targeting in Canada** - [How to Improve Inflation Targeting in Canada (Markdown version)](/external/pubs/ft/wp/2016/wp16192.pdf.md){rel="alternate" type="text/markdown"} - [How to Improve Inflation Targeting in Canada (PDF)](/external/pubs/ft/wp/2016/wp16192.pdf){rel="external" type="application/pdf"} --- ## References - [https://www.imf.org/wp-content/uploads/2016/10/canada-chart1.jpg](https://www.imf.org/wp-content/uploads/2016/10/canada-chart1.jpg) - [https://www.imf.org/wp-content/uploads/2016/10/canada-chart2.jpg](https://www.imf.org/wp-content/uploads/2016/10/canada-chart2.jpg) - [United States](https://blogs.imf.org/2015/06/25/u-s-monetary-policy-avoiding-dark-corners/) _Source: https://www.imf.org/en/blogs/articles/2016/11/01/strengthening-canadas-economic-toolkit-improving-the-inflation-targeting-framework_