Understanding inflation targeting

At the Bank of Canada, we aim to keep inflation close to 2 percent.

Why we target inflation

As Canada’s central bank, our job is to promote the economic welfare of Canadians. We target inflation because a low, stable and predictable rate of inflation is good for the economy. When people and businesses feel confident that they know what the rate of inflation will be, they can make long-range financial plans. That leads to an economy that functions better. Average economic growth is stronger, and employment is higher.

When we started

Inflation was a serious problem in Canada in the late 1970s and throughout the 1980s. Annual inflation reached more than 12 percent in 1981. The government and the Bank of Canada wanted to gradually reduce inflation. After trying a few different approaches, we agreed in 1991 to aim for an inflation target of 2 percent. The goal was to reach this target by the end of 1995.

When we successfully brought inflation down to 2 percent, we found that this target resulted in good overall economic performance. We renewed the agreement at the end of 1995 and have done so several times since.

With inflation targeting, price increases in Canada have averaged around 2 percent for three decades. Plus, it has led to low and stable borrowing rates for consumers and businesses.

How we achieve our target

In our experience, inflation tends to be close to the 2 percent target when the economy is running near its capacity—when demand for goods and services is roughly equal to what the economy supplies.

• If demand is greater than what the economy supplies, this can push inflation above our target.
• If demand is less than capacity, this can pull inflation below 2 percent.

We use our monetary policy to try to keep the economy operating close to its capacity. The tool we use is the policy interest rate, which is also known as the target for the overnight rate. This is the interest rate major banks charge for overnight loans to one another.

Targeting in action

Let’s say the economy is running below its capacity and inflation is falling below target. In this situation, we may lower our policy interest rate. When this happens:

1. Other borrowing costs tend to fall as well, such as interest rates for mortgages and car loans.
2. Since it’s cheaper for households and companies to borrow money, they feel encouraged to spend and invest. As a result, demand in the economy goes up.
3. The higher demand brings the economy closer to its capacity and helps inflation move closer to target.

The process also works in reverse. Demand may be too strong and may push the economy above its capacity. In this situation, we might raise our policy rate to stop inflation from rising above target. When this happens:

1. Other interest rates tend to rise.
2. Borrowing becomes more expensive, and demand in the economy tends to decline.
3. The lower demand brings the economy back down toward capacity and pulls inflation down closer to target.

But it takes some time (usually between 18 and 24 months) for changes in interest rates to affect every part of the economy. So we set the policy interest rate based on where we expect inflation will likely be in about two years, not where it is today.

Flexibility is important

Prices can jump around for all kinds of reasons. For example, extreme weather can lead to higher prices for food or gasoline. Inflation rarely stays at exactly 2 percent for very long, even in a stable economy. This means that while we aim for 2 percent, our inflation target sits in the middle of a range from 1 to 3 percent.

But we don’t make our monetary policy decisions in isolation. We know they can affect things like household debt, which can make the financial system unstable. So our monetary policy is flexible. For example, we might change rates more slowly if moving faster could make the financial system more vulnerable to a big economic crash later on.

A balanced approach

We worry just as much about inflation falling below the target as rising above it.

• When prices go up too quickly, money can’t buy as much as it used to. That loss of purchasing power hurts everyone’s standard of living, especially those on fixed incomes.
• In contrast, inflation that is below our target is a sign that the economy is struggling, with lower production and fewer jobs.

Over time, we have found that a target of 2 percent promotes balance in the economy and growth that people can count on.