Patrick Grady
Dodge's Moment of Truth
Financial Post, Wednesday, February 26, 2003, p.FP19

Canada's monetary policy has been well guided by inflation targets for more than a decade in achieving its goal of "low, stable and predictable inflation." During this period, the Bank of Canada has been remarkably successful in keeping inflation within the target bands and usually near the target midpoint. However, recently inflation has begun to rise again, breaking out of the upper target bound and with tomorrow's release of new CPI figures, we may well find that they have once again gone higher.

The moment of truth is fast approaching for Bank of Canada Governor David Dodge. Barring the unexpected, he will soon have to raise the policy interest rate to show that the bank remains fully committed to meeting its inflation targets. Otherwise he risks compromising the bank's credibility.

Monetary targets were first established by a 1991 agreement between Conservative Finance Minister Michael Wilson and Bank of Canada Governor John Crow. The initial targets, which the Finance Minister proposed, were to reduce inflation as measured by the consumer price index to 3% by the end of 1992 and 2% by the end of 1995 (with a one-per-cent band on either side). At the insistence of Governor Crow, the joint release also included a commitment to achieve the ultimate objective of price stability, which was specified as meaning inflation "clearly below 2%."

The Bank of Canada under John Crow's firm tutelage was successful in bringing inflation down to below 2% in 1992 and 1993, perhaps too successful as inflation continued to fall averaging around zero in 1994, even though core inflation, which excludes the most volatile components and the effect of changes in indirect taxes such as the large cuts in tobacco taxes that occurred in 1994, remained near 2%.

Disagreement over the inflation targets played a key role in the failure of the newly elected Liberal Government to reappoint John Crow in 1994. The new Governor Gordon Thiessen was appointed only after he agreed to accept the Government's proposal to keep the 1 to 3 per cent target, and not to lower it further as would be required by the pursuit of "price stability."

During Gordon Thiessen's term as Governor from 1994 to 2001, the Bank of Canada also succeeded at meeting its targets. In 1995, inflation moved back into the middle of the target band, where it stayed through 1997. After falling towards the lower end of the band in 1998, the total consumer price index began to increase steadily in 1999, going only briefly outside the upper band in November and December 2000. During this same period, the core consumer price index drifted down, touching the bottom of the band in September 2000 before beginning a steady climb that took it back to the middle of the target band by the end of 2000.

When David Dodge took office as Governor in February 2001, inflation was already near top of the target band, although core inflation was still below the target midpoint. Under his governorship, the "inflation-control targets" were renewed in May 2001. The Bank of Canada was an active participant in the process this time, preparing background documents on the appropriate targets and on whether they should be raised or lowered. The Bank found no convincing evidence that, on the one hand, "targeting inflation rates of ...less than 3% could lead to significant economic difficulties" and that, on the other, "the benefits of a lower target inflation rate are large enough to justify the change to a lower target." Governor Dodge was thus quite comfortable endorsing the joint statement announcing "the inflation-control target range will continue to be 1% to 3%" until the end of 2006 and that the bank "will continue to aim at keeping the trend of inflation at the 2% target midpoint."

Since the renewal of the targets and in the wake of the geopolitical events set in train by the September 11 terrorist attacks, it has been rough sledding for monetary policy. Following September 11, the bank, appropriately, cut the overnight rate aggressively to bolster confidence. However, by early spring of 2002 it had become evident that the Canadian economy was much stronger than expected and that inflationary pressures were building. Since then, inflation has risen sharply. The bank responded by raising the overnight rate three times between April and July by a total of three quarters of a percentage point.

Total consumer price inflation was driven by higher gasoline, fuel oil and natural gas prices, and core inflation was bolstered by special factors including premium increases for auto and home insurance, electricity price increases in Ontario, and the echo effect of temporary price discounting following September 11. While one-off factors have been important in the run-up in inflation, the evidence based on the available indicators cited by the Bank suggest that the economy is operating close to capacity and that this is contributing to a broadening of price pressures. From a policy perspective, the objective is to keep a balance in aggregate demand/supply going forward so as not to generate persistent pressures on inflation. By November 2002, total consumer price inflation at 4.3% was well above the top of the target range. Even core inflation at 3.1% was outside the range.

Governor Dodge reported in a January speech in Toronto that "with oil and gas prices where they are now [US$30 per barrel then, above US$36 now], we could see CPI inflation rates between 4% and 4.5% in the first quarter." He also said that "monetary policy remains stimulative" and that "to return inflation to the 2% target over the medium term,....we will need to raise interest rates." But on January 21 in spite of the greater than expected increases in both core and total CPI inflation, the Bank of Canada had announced that it was "maintaining its target for the overnight rate at 2 3/4%. The main factor holding the bank back from raising interest rates by the amount necessary to return inflation to the 2% target over the medium term are geopolitical and economic uncertainties related to the upcoming Iraq war and the prospects of terrorism.

Tomorrow's consumer price index will show January results. If it is as bad as expected, or worse, Governor Dodge will have no choice but to raise the key policy rate on March 4, when the bank's next policy announcement of the bank's Governing Council is scheduled. If he fails to do so, people will begin to question his commitment to the inflation targets. It is the credibility of these targets that has underpinned public expectations of low inflation and contributed to the last decade's good economic performance. If moderate monetary restraint is not introduced in a timely fashion, more drastic and painful restraint will be required later.