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The inflation-control target

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So, the 2 per cent inflation target has been renewed as it now stands. (Take that, House of Commons Finance Committee, which is holding hearings on the issue next week.)

The background report from the Bank of Canada is pretty self-congratulatory, though it does somewhat revise the current regime to underline the point that monetary policy also needs to take financial stability into account. While stressing that regulation (credit controls, direct regulation of financial institutions) should be the first line of defence against potentially destabilizing private credit bubbles, the report underlines that central banks may have to take more than the rate of inflation into account when setting interest rates.

But the word "unemployment" is barely to be found in the report. This reflects the conventional wisdom that a 2 per cent inflation target is quite compatible with low unemployment so long as the labour market is "flexible."

The left sometimes under-estimates the costs of inflation, which undermines the purchasing power of wages and of savings for retirement. We need to remind ourselves that the stagflation crisis of the 1970s discredited the Keynesian consensus supporting full employment and opened the intellectual and political door to neo-liberalism. I don't take particular issue with the idea of an inflation target, though 2 per cent is probably too low since a very low inflation target can impede nominal wage adjustments in response to economic shocks, and since it effectively forecloses negative real interest rates as a way of boosting demand and jobs.

That said, I do think that the central bank should have a dual mandate to pursue both a reasonable inflation target and a target for low unemployment, as is the case in the United States, as was the case in Canada, and as is still implied in the preamble to the Bank of Canada Act itself.

"WHEREAS it is desirable to establish a central bank in Canada to regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada."

Lars Osberg recently reminded us that setting a target for inflation but not for unemployment predisposes the central bank to focus one-sidedly on the former. If the Bank of Canada only has an inflation target, then it will likely hit it pretty consistently (as it has.)

But Lars argues that a rather wide RANGE of unemployment rates may be consistent with stable inflation. Thus there will be a significant and ongoing cost attached to minimizing inflation risk as opposed to trying to balance inflation and unemployment risk. Before the recession, we may have been able to push the national unemployment rate down to 5 per cent without pushing inflation above 2 per cent, but the Bank of Canada never tried. The cost of not pushing for lower unemployment is to be counted in terms of lower output, and also lower potential output. He also emphasizes the very real human costs of unemployment as identified in recent research on happiness and well-being.

I guess no one over at the Bank of Canada feels a need to respond to such heresies.

This article was first posted on The Progressive Economics Forum.

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