According to "divine coincidence", the monetary policy that is best for stabilising inflation is also best for stabilising real output. Divine coincidence seems to be holding up fairly well in Canada. But the recent UK experience is a case where divine coincidence has failed.
The Bank of Canada's inflation target is up for renewal this year. Canadians spend too much time looking at the US. I think we could learn more by looking at the UK. The Bank of England, like the Bank of Canada, has been targeting inflation. And the UK, like Canada, is a more open economy than the US. Which is why I find the recent UK experience worrying.
What's worrying about the UK is that the inflation rate is above target, but the country is still deep in recession. That's not true in Canada. But it might have been. We ought to pay attention, because Canada might be in that same situation in future, if we are unlucky.
Scott Sumner argues that the UK experience shows the failure of inflation targeting. His own preference is for targeting the path of Nominal GDP. He's got a point. Does anyone really want to say that UK monetary policy has been too loose over the last two years? But if we look only at the inflation rate, which is above target, that is what we are forced to say. If we look at NGDP, we can say that monetary policy should have been looser, and needs to stay loose.
Thanks to Stephen for doing this graph for me: to compare Canada and the UK; CPI and Nominal GDP (both in levels):
For Canada you see a clear slowing of the CPI inflation rate beginning mid-2008, with even a slight fall in the price level. Inflation only recovers at the end of 2010. Clearly, in hindsight, monetary policy was too tight, because it allowed inflation to fall below target.
For the UK you see a very short dip in inflation in the second half of 2008, then it immediately recovers. Someone looking only at the CPI would see almost no sign of any lack of aggregate demand in the UK at all. Recession? What recession? Inflation rose above the 2% target, so UK monetary policy must have been too loose?
It's only when you look at the solid line for NGDP that you see the UK recession.
Both countries show divine coincidence before mid-2008. Both CPI and NGDP are growing smoothly. Canada continues to show divine coincidence throughout. You see the same recession in both CPI and NGDP. By either measure, monetary policy was, with hindsight, too tight. But divine coincidence fails in the UK.
I can think of four ways in which Canada has been different from the UK in the recession:
1. UK banks went bad; ours didn't.
2. The UK has had to tighten fiscal policy; Canada was able to loosen fiscal policy.
3. The pound depreciated; the Loonie didn't.
4. The UK has increased VAT (update: from 15% to 17.5% in January 2010 and to 20% in January 2011, thanks Matteo); Canada hasn't.
1 and 2 have meant that the Bank of England's monetary policy has had to be more aggressive than the Bank of Canada's.
3 and 4 are possible explanations for the high UK inflation, despite weak signs of any real recovery. They are possible explanations for the failure of divine coincidence. (But the second VAT increase only took effect in January 2011, so is not included in Stephen's graph).
I really don't like the thought of changing the Bank of Canada's inflation target. It has worked well. It ain't broke so don't fix it. Learning the 2% target was a big investment, by the Bank and by everyone else. A lot of people have made plans based on that 2% target. It has a quasi-constitutional status. We need a stable monetary order as part of the background people rely on. We can't change monetary policy to follow the latest academic fads.
But the UK experience is forcing me to reconsider.
The Bank of Canada has finessed the question of divine coincidence in the past. When the GST (VAT) was first introduced, they recognised it would cause a one-time increase in the CPI. But the Bank made no attempt to tighten monetary policy in anticipation. The Bank said it would allow the "first-round effects" of the GST, but would only try to ensure there were no "second round effects". It "looks through" one-time increases in the CPI. It invokes core CPI as its "operational guide". And we've been lucky too, because increases in oil prices tend to coincide with an appreciating exchange rate, which has an offsetting effect on the CPI. My guess is that this is the biggest reason why divine coincidence seems to work better in Canada than the UK.
The current failure of divine coincidence in the UK is getting too big for the Bank of England to finesse so easily. Eventually, unless our luck holds forever, Canada will also face a failure of divine coincidence too big for the Bank of Canada to finesse.
My colleagues Chris Ragan(pdf) and Angelo Melino(pdf) on the CD Howe Monetary Policy Council want the Bank of Canada to lower its inflation target. Some economists believe that monetary policy is impotent when it hits the zero lower bound, and so would be strongly against lowering the inflation target. I don't believe monetary policy is impotent at the zero lower bound. But I really don't want to test whether I am right on that question more than once a century.
If we do change the Bank of Canada's 2% inflation target, there has to be a very good reason for doing so. Swapping 2% for 1% inflation, just seems like tempting fate for minimal gains. Swapping inflation targeting for NGDP level targeting might be worth thinking about. But I think it's not even on the agenda.