Has the Bank of Canada developed a credibility problem?

Andrew Coyne says the Bank of Canada has abandoned its policy of targeting inflation, allowing prices to increase in order to accommodate a lower Canadian dollar. Coyne says that this new policy objective is the result of direct interference from the Federal Finance Minister. I think that's ridiculous. Let's discuss.

Coyne's evidence of the shift in policy:

  • Finance Minister Jim Flaherty said earlier this month that a lower dollar would be good for exports and the economy, and that interest rates would rise later this year.
  • A resurgent manufacturing sector in southern Ontario would be good for Tory election prospects.
  • Flaherty is rumoured to have been heavily involved in the selection process of appointing Governor Poloz.
  • Poloz used to work at Export Development Canada.
  • The Canadian dollar fell after the latest policy rate announcement. 

All these points are true. The first one is especially irresponsible for a Finance Minister. But why do they imply that the Bank of Canada has abandoned targeting inflation for the exchange rate? We have to check if the Bank of Canada really has abandoned its inflation target (keep in mind that this target is legislated — the Bank is obligated by law to pursue it).

To start, nowhere in the Bank's recent Monetary Policy Report or in Poloz's public statements is there any mention of a desire to see a lower dollar. Indeed, the day after Flaherty's irresponsible comments, the governor went out of his way in an interview with CBC to say that the Bank does not care about the exchange rate. And many, many times, in every publication and news release, the Bank has said over and over again that it only cares about inflation. That has been true for years and it has not changed under Poloz. Poloz is in fact the first governor to describe the inflation target as "sacrosanct." All monetary policy at the Bank of Canada is viewed through the lens of inflation. If you don't understand this, you will not understand the Bank of Canada.

But those commitments are just words. What has actually happened — is inflation staying on target? Coyne says that inflation is currently not that far below target and that the dovish language in this week's policy announcement was thus unwarranted to maintain the Bank's target. But that's not true. To see, you just need to graph it:

Canada.CPI.png

Since inflation targeting began, inflation has been following a consistent trend. But somewhere in 2011, inflation slowly began to diverge below trend. That is, inflation has actually been too low. It's very slight, but the Bank of Canada does not wait for huge divergences to act — it tries to steer inflation in real time. As you can see, this divergence is the biggest since inflation targeting began. This is what Poloz means when he says that inflation has been "too low for too long."

 (The Bank says that it targets the inflation level and not the path of CPI above, but never mind that. If you don't believe me, think of the Bank as targeting the slope of the graph above and the argument still holds.)

The point is, to stay on target, the Bank clearly needs to loosen policy, which it has done this week. And looser policy happens to also depreciate the dollar. So what? This doesn't mean the Bank is now targeting the exchange rate instead of inflation. It is not. The Bank cares about inflation — and it only cares about the exchange rate insofar as it affects inflation.

That's what the Bank says and the evidence is consistent with that. All the evidence suggests that the Bank of Canada is simply following its inflation mandate. There is no conspiracy.

But Coyne's tirade does raise an important issue: Does the Bank of Canada have a communication problem? Is Coyne some crank pundit trying to sell a headline or should his complaints be taken seriously? I don't know. (Coyne's father was governor of the Bank of Canada many decades ago and was instrumental in establishing central bank independence, but I don't think intellectual authority can be inherited.) Though Coyne emphasizes interference by the Federal Finance minister, several other news agencies also reported this week that the Bank of Canada is attempting to devalue the Canadian dollar — it's just not true.

Many people think that the Bank of Canada works by adjusting interest rates, but that's not actually true. In fact, in the policy rate announcement this week that Coyne has taken issue with, there was actually no change in the policy rate whatsoever. The dirty secret of monetary policy is that the real tool is in communication, for reasons we won't get into right now. If the Bank is failing to communicate its objective, if its credibility is in jeopardy, the Bank of Canada has a serious problem.