Inflation targeting’s Canadian roots
In a recent visit to Israel, I had the pleasure of catching up with an old friend from Canada, Charles (“Chuck”) Freedman. His may not be a household name in Canada, much less in India, but it ought to be: He fairly deserves credit for being one of the early pioneers of inflation targeting, a monetary policy paradigm which became orthodoxy during the course of the 1990s and 2000s and has even survived the global financial crisis relatively unscathed. With impeccable credentials as an economist (Toronto, Oxford, and finally Massachusetts Institute of Technology, where the legendary Charles Kindleberger supervised his doctoral thesis) and a stint teaching at the University of Minnesota in its heyday, Freedman joined the staff of the Bank of Canada, finishing his tenure with distinction, retiring in 2003 as deputy governor. Thereafter, he joined Carleton University, where I teach, as an adjunct professor, and co-founded a research centre on monetary and financial economics.
Over lunch at the Bank of Israel, and later coffee and dessert at the famous King David Hotel in Jerusalem, we chatted about his time at the Canadian central bank, at a pivotal moment in the evolution of monetary policy, not just in Canada but throughout the world. What follows is based in part on these conversations, as well as notes for a 2014 talk, “The Origins And Early Years Of Inflation Targeting In Canada”, which Freedman graciously shared with me. The usual caveat, that judgements are mine and should not be attributed to Freedman or anyone else, of course holds.
Readers will be aware that the 1970s and 1980s witnessed considerable tumult in the global economy, with stagflation in the US and other advanced economies, followed by a prolonged period of monetary tightening, in which high interest rates were used to slay the dragon of high and persistent inflation. Canada had its own version of the US inflation hawk Paul Volcker in John Crow, who was central bank governor from 1987 to 1994, and under whose tenure high interest rates were used to try to achieve “price stability”. There is ongoing debate on whether by this he meant literally zero inflation, or a low and acceptable rate of inflation. As we know, the doctrine of inflation targeting as it developed during the 1990s fixed on the latter definition, in practice, around 2% in many advanced economy inflation targeters.
Achieving low and stable inflation is a laudable goal, but how can this be done? This was perhaps the main conceptual breakthrough of the early pioneers of inflation targeting, which was to move away decisively from the old paradigm of monetary targeting, towards targeting the path of the inflation rate directly, and using the policy interest rate as the principal instrument by which to achieve the target. Monetary targeting, which had been in vogue earlier, thanks in part to the fact that the Nobel economist Milton Friedman had advocated it, came a cropper, because targeting the growth of a monetary aggregate had failed to deliver a predictable inflation rate, in large part because of the instability of money demand. A new paradigm was clearly needed.
In the late 1980s, as Freedman and other Canadian officials were thinking through alternatives, no other large advanced economy was as yet an inflation targeter. The only advanced economy which had already adopted this new approach was New Zealand, but this was a small economy on the other side of the planet, and it was not clear what, if any, relevance there might be for a G7 economy such as Canada. As it happens, Canada’s explicit adoption of flexible inflation targeting as its monetary policy paradigm finally occurred in 1991, making it the first G7 economy to do so, and an exemplar for other advanced and emerging economies which were to follow suit in subsequent years.
What is more, some of the details of how to do inflation targeting—target consumer price index (CPI) inflation, not the gross domestic product (GDP) deflator, set a band within which inflation would be allowed to fluctuate, and so forth—followed from the Canadian experience, and have found resonance in other inflation targeting economies, including India. Freedman emphasizes that the band should be seen as an “uncertainty band”, not a “tolerance range”, reflecting uncertainty over the effects of current policy on future inflation, rather than a tolerance for inflation deviating from its target.
After an initial period of scepticism about the new paradigm—one could “cut the scepticism with a knife”, as Freedman puts it—inflation very rapidly declined and has remained low and predictable ever since. With strong financial institutions, Canada weathered the global financial crisis relatively unscathed, with the inflation targeting regime never seriously coming into question in that country, as it has in some other countries since the crisis. Furthermore, Canada’s experience with this new paradigm provided a knowledge base for other adopters, including India.
Looking back, Freedman believes that flexible inflation targeting has been key to creating a sound macroeconomic policy framework in both advanced and emerging economies. On India, he argues that our recent adoption of inflation targeting will have a similarly positive impact. Our early experience under Reserve Bank of India governor Urjit Patel augurs well.
Every fortnight, In The Margins explores the intersection of economics, politics and public policy to help cast light on current affairs. Read Vivek’s Mint columns at www.livemint.com/vivekdehejia