Stephen Poloz may let inflation creep higher: Don Pittis

Which would you prefer, higher interest rates or higher inflation?

If you are someone who actually watches what the Bank of Canada does month to month, its two per cent inflation target may seem sacrosanct.

In which case, you might be surprised to hear that the concept of raising or lowering interest rates to freeze inflation at exactly two per cent is a relatively recent innovation. It was put in place in reaction to the soaring prices and wages of the 1970s and 1980s. 

And the Bank of Canada has been seriously considering changing that target. Any change would still require a new agreement between the federal government and the bank. The current agreement is scheduled to end next year.

A fresh report from the business news service Bloomberg implies that the bank could surprise us with just such an announcement any time soon. [See clarification below].

"After shocking markets with an interest rate cut in January," wrote Bloomberg's Greg Quinn, "Bank of Canada Governor Stephen Poloz is considering whether to deliver another surprise: changing the central bank's two per cent inflation target." 

'No surprise'

Quinn does not offer the source for his latest story, but he follows the bank's activities assiduously. The Bank of Canada, on the other hand, was quick to play down the story.

"It is absolutely wrong to characterize research done by the bank on the implications of a higher inflation target as a surprise," said an official bank spokesperson in response to my inquiry as to whether the Bloomberg story was true.

While research on the subject is definitely not a surprise -- since last November the bank has informed Canadians they are studying the issue -- an imminent announcement by the Bank of Canada would indeed be a shocker.

And the impact on Canadians could be significant.

Raising the inflation target is by no means some mad idea out of the blue. As recently as June 2014, a working paper published by the International Monetary Fund, The case for a long-run inflation target of four per cent, made the case that central bank targets should rise.

Zero bound

"A four per cent target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe," says a description of the essay, which the IMF says is by no means IMF policy."This benefit would come at minimal cost, because four per cent inflation does not harm an economy significantly."

That "zero bound" reference refers to the difficulty many central banks are facing now. In order to hold inflation down to two per cent, the key rates set by banks are effectively as low as they can go, bumping up against zero. Lowering rates into the negative, tried some places in Europe, just encourages savers to hoard cash.

• Central banks can't rescue us from wobbly world markets 
• Low rates mean central bankers can't fix the economy

But besides solving the zero bound problem at some point in the future, raising the target rate would have an impact now. And different people would be affected differently.

In the short term, an increase in the target rate would mean Poloz would be in no rush to raise rates if the increase in the cost of living began to creep up. That means if higher oil prices continue to rise over the summer, for example, leading to increases in the cost of fuel and shipping — feeding through to food and other goods — interest rates would remain at current lows.

At first blush, that sound good, especially for the sake of the short-term economy. Businesses and homeowners could continue to borrow and spend. The housing market would continue to surge, especially in Toronto and Vancouver.

Slamming the brakes

But if inflation began to rush up toward the new target, eventually the central bank would have to slam on the brakes with even higher interest rates than they might have otherwise.

• The interest rate danger of runaway inflation

If four per cent inflation were to become the new normal, there would be other effects as well -- many of them not so clear. Cash savings would fall in value as money bought four per cent less each year. Wage earners would clamour for higher pay. Banks and other lenders would have to re-examine real asset values.

Because of all those uncertainties, Poloz and his advisers will study the issue very carefully before making any such announcement.  

As the Bank of Canada spokesperson said: "In all of our communications on possible adjustments to the inflation target, we have been careful to note that the bar for changing the agreement is high."

Which would only make such an announcement, if it were to happen, even more of a surprise.