Is the Bank of Canada's 2% inflation target too low?

The Bank of Canada reiterated last week its willingness to increase interest rates again in the coming months if required to bring inflation down to 2%. But is that too rigid a figure for the central bank to target?

Like the US Federal Reserve, European Central Bank, and Bank of England, the Bank of Canada has long viewed 2% as the ideal resting point for annual growth in the consumer price index (CPI).

That sweet spot marks the point at which “the economy is running near its capacity – when demand for goods and services is roughly equal to what the economy supplies,” according to the Bank.

Since March 2022, the central bank has embarked on an aggressive path of interest rate increases aimed at bringing inflation – which shot to a 39-year high in June of that year – towards the 2% target.

Exactly 12 months after hitting that peak, inflation had tumbled to 2.8%, its lowest level for two years – but surprisingly ticked back upwards in July, and with further increases expected in the coming months, the Bank has maintained a warlike stance on the possibility of further hikes.

Could central banks settle at a higher inflation target?

In the United States, much discussion has centred recently on the question of whether the Fed could afford to target a higher inflation rate than 2%, reducing the need for rate increases and potentially spelling welcome relief for homeowners and buyers whose budgets have been pummelled by higher mortgage borrowing costs.

That’s a conversation worth having north of the border, too – but not at present, according to BMO’s chief economist Doug Porter (pictured top left), who told Canadian Mortgage Professional that increasing the 2% target would be unwise during a time of substantial economic turbulence.

“We had 30 years from the early 1990s to basically the early days of the pandemic where inflation averaged just a little bit less than 2%, so that’s a long stretch in history where 2% was really not a problem,” he said.

“I think it’s a reasonable debate to be had. I just don’t think when you’re trying to fight back inflation that this is a good time to be having that debate. You don’t want to move the goalposts in the middle of the game.”

With inflation still running well over the Bank’s current target, it would make little sense to change the target now, Porter said, with a number of years in the 2-3% range required before any substantive discussion on the issue takes place.

“Keey in mind it was just at the end of 2021 that the Bank of Canada and the government reset the target at 2% for another five years,” he noted. “So realistically, it can’t be revisited until the end of 2026 in any event.”

ICYMI: Governor Tiff Macklem unpacks the current state of the economy and the promising signs we are seeing in rebalancing supply and demand.https://t.co/bXXrwmAsd1#cdnecon #economy @CalgaryChamber pic.twitter.com/K4abQSLTR1

— Bank of Canada (@bankofcanada) September 8, 2023

How close to 2% is close enough for the Bank of Canada?

A key question for the Bank of Canada will be what constitutes a level of inflation that’s close enough to 2% to justify leaving interest rates where they are, according to CIBC deputy chief economist Benjamin Tal (pictured top right).

He told CMP that the 2% figure was possibly “open to interpretation” with a level a few basis points above that number probably acceptable for the central bank to eventually leave rates unchanged.

“We have to remember when 2% was the target for the past 20 years, the average was really 1.8%, not 2%. We were below,” he said. “So what happens if it’s 2.2%, 2.3%, 2.4%? Close enough? You can put a spin and say that it’s close enough.

“On average, it will be 2% from a long-term perspective, [so] therefore we can leave it at 2.5%. You don’t have to bring it to 2%. I think that’s the way to look at it [with] the way it was undershooting for long periods of time.”

The central bank will not “tip the economy” over inflation that remains slightly higher than 2%, Tal said – but there’s no imminent prospect that it will readjust its inflation target in the short term.

“You can make the point that maybe a new target is needed given the structural change of the economy, but from a practical perspective this is an academic discussion,” he said. “It’s not going to happen.

“For 20 years they told us that the number is 2%. So in order to change it from two to three, you have to come up with PhDs, studies, research coordinate with [other] central banks… They cannot just raise it like that because they feel like it, because then they will lose credibility.”

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