Inflation, which refers to the rise of goods and service prices over time, is an important way to measure Canada’s economic health. The Bank of Canada sets a target for inflation every five years; if it hits the target, it’s a sign that the economy, and consumer spending, is in good shape. In order to control the rate of inflation, the BoC adjusts interest rates. For example, a low cost of borrowing further promotes spending, which in turn props up inflation. This is the current scenario in Canada: The BoC has kept interest rates very low since the 2008 recession to protect the inflation target, and to promote economic recovery.
Also read: What are Bank of Canada Rates?
However, this strategy could be in for a change. The BoC recently stated that it is considering upping the target for inflation at its 2016 renewal date. Doing so would give the central bank more wiggle room to slash interest rates in the event of an economic crisis; currently, they’re only 0.75 per cent from absolute zero. This appears to be Bank of Canada Governor Stephen Poloz’s main concern.
So would changing the target be beneficial to Canadians – or is it a sign of dire economic times? Here’s our breakdown.
The Pros of Changing the Inflation Target
One of the lessons we learned from the last financial crisis is that a 2 per cent inflation target leaves very little room to respond. Perhaps the biggest argument in favour of a higher inflation target is that the Bank of Canada would be less likely to cut interest rates right away to boost economic growth, and avoid setting them at zero. When interest rates reach 0 per cent, it greatly limits the Bank of Canada’s ability to respond to an economic crisis since, in theory, it can’t cut interest rates any lower.
With low growth the new norm in Canada, disinflation – a decrease in the rate of inflation – is also major concern. A higher inflation target would help avoid this scenario, and combat slower economic growth from an aging workforce. With the baby boomers set to retire over the next couple decades in droves, changing to the inflation target would help deal with the looming labour shortage.
The Cons of Changing the Inflation Target
As the saying goes, if it ain’t broke, don’t fix it. The inflation target has worked well at 2 per cent, and tinkering with it can lead to all sorts of unintended consequences.
First of all, changing the inflation target would be bad news for bond investors, as it would lessen the value of fixed coupon payments. It would be equally bad news for the Canadian dollar; the loonie would most likely take a nosedive in response to a higher target inflation.
Changing the target would also signal instability in Canada’s economy – a sign that could make markets nervous, and create further distrust in Poloz’s leadership. The BoC governor is already known as a bit of a loose canon in the financial community. Following the surprise rate cut in January that caught both economists and banks off guard, Poloz has provided guidance that markets have perceived as confusing. Changing the inflation target would only magnify that reputation and could downgrade Canada’s reputation in the world markets. If Poloz changes the inflation target next year, what’s to stop the Bank of Canada from changing it the next time it comes up for renewal?
While there are arguments on both sides of the fence, is will be interesting if Poloz decides to go with the status quo or opts to change things up a little.
Sean Cooper is a Financial Journalist and Personal Finance Expert, living in Toronto, Ontario. He offers Unbiased Fee-Only Financial Advice, specializing in pensions and the decumulation of financial wealth in retirement. Follow him on Twitter @SeanCooperWrite and read his blogs and request his writing services on his personal website: http://www.seancooperwriter.com/