OTTAWA (Reuters) - The Fed’s historic decision on Wednesday to target 2 percent inflation marks the second time in less than a year it has followed in the footsteps of the Bank of Canada, which credits its 21-year old inflation target with helping it weather the global financial crisis.
By setting the inflation target, seen as a major victory for Chairman Ben Bernanke, the U.S. Federal Reserve aligned itself with the many central banks that have used numerical inflation targets for years.
In August 2011, the Fed also borrowed from the Bank of Canada’s playbook when it said it would likely keep rates near zero for two years, parallel to a rare commitment Canada’s central bank made in the depths of the 2008-09 recession.
The Bank of Canada first announced an inflation target in 1991, making it an early adopter of a policy since matched by the Bank of England, the European Central Bank and others. Since the end of 1995 it has aimed at a 2 percent annual inflation rate, the midpoint of a 1 to 3 percent control range.
It recently mulled alternative targets, but said last November that the inflation target had been so successful that the government and central bank would renew it unchanged for another five years.
“There’s been very little variability around that 2 percent,” said Mark Chandler, head of fixed income and currency strategy at RBC Capital Markets. “And inflation expectations, depending on how you measure them ... have also been very closely aligned,” he said.
Chandler said that while technically the bank has achieved the target most of the time, it was less clear that other economic metrics like productivity have benefited from the fixation on prices.
The central bank says the inflation target ended the boom and bust economic cycles of the 1970s and 1980s, bringing average growth of about 3 percent. Inflation eased, mortgage and commercial rates for borrowers declined and employment grew more quickly, at about 2 percent a year.
Perhaps most importantly, it says businesses and individuals now truly believe in the bank’s ability to keep prices stable and relatively low, an incentive to make long-term spending decisions and help the economy grow.
“Even throughout the financial crisis of 2008-09, business expectations of inflation remained well-anchored at 2 percent. This suggests that the credibility of the bank’s inflation target has been solid, even during the recent very difficult times,” the bank said in a November 2011 statement.
While analysts think the Fed may have introduced the inflation target to quell doubts about a nasty bout of inflation in the future as a result of monetary easing, Canada’s 1991 move was in response to past inflationary spells.
Initially, it aimed to bring inflation down to 3 percent by the end of 1992, to 2 1/2 percent by the middle of 1994 and to 2 percent by the end of 1995.
Unlike the Fed, the Bank of Canada does not have a dual mandate that covers both inflation and employment and Governor Mark Carney dismissed an employment target as a bad idea when some legislators proposed it last year.
He said it was tried in the 1970s and had negative effects both on inflation and employment.
Reporting By Louise Egan; editing by Janet Guttsman