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OTTAWA (Reuters) - Cutting the Bank of Canada's inflation target would likely be a good idea, a research paper done by the central bank said on Thursday, hinting at a move that would have a big impact on markets and the economy.
The Bank of Canada, which aims to keep inflation near the midpoint of a 1 to 3 percent range, agreed with the federal government in 2006 to stick with this target until the end of 2011. But it said at the time it would research potential improvements.
The new paper, published Thursday in the quarterly Bank of Canada Review, suggested the economy may operate more smoothly if the central bank kept an even tighter lid on rising prices.
"The earlier literature and recent studies at the Bank of Canada suggest that an inflation target lower than 2 percent may be beneficial," it said.
"An inflation target below 2 percent is likely preferable to the status quo," said the paper, entitled "Next Steps for Canadian Monetary Policy."
Bank of Canada Deputy Governor John Murray said in an introduction to the current review that further work would be done to examine the conclusions. He also said the optimal inflation rate varies from study to study.
The central bank has noted in the past that even at 2 percent the erosion of purchasing power can still pose a serious problem on a cumulative basis, particularly for pensioners on fixed incomes.
While the review has no near-term monetary policy implications, it can be used to handicap the odds that Canada might eventually pursue a lower inflation target, or a different means of addressing prices altogether, said Eric Lascelles, chief economics and rates strategist for TD Securities.
"It is notable that the Review offers up little resistance toward the notion that the inflation target should be lower," he said in a note to clients.
"Given a dearth of specific information, we are left to fall back on previous projections we have made on the subject, which is that there is a 15 percent chance of a cut in the inflation target in 2011 (we assume to 1.50 percent from 2 percent)."
He noted that, in the long term, a lower inflation target would likely lead to lower nominal bond yields and a relatively stronger currency.
All four research papers published in the current issue also referred to possible benefits of shifting away from an inflation target to a price-level target, though the research also suggests some drawbacks and the need for more study.
Under inflation targeting, the bank does not try to compensate for past mistakes -- if it overshoots a 2 percent target, it does not aim to undershoot the following year but keeps its sights set on returning to the 2 percent target in the medium-term.
Under price-level targeting, the bank would aim for a specific numeric value in the consumer price index and would try to reverse any past deviation from that target. If the target had been overshot, this would mean temporarily tighter monetary policy than otherwise would have been warranted.
Murray said one of the potential benefits of targeting prices is reduced uncertainty about the level of prices.
However, the paper said: "It is not yet clear whether a price-level target would be preferable to our current inflation target. Further research into price-level targeting is thus a priority for the bank's economists."
The Bank of Canada said it had a positive experience so far with its 2 percent inflation target but concluded that "there may still be room for improvement in the Canadian monetary framework."
Reporting by Randall Palmer and David Ljunggren; Editing by Jeffrey Hodgson