February 18, 2010 / 5:24 PM / in 8 years

Bank of Canada: inflation horizon may be shorter

OTTAWA (Reuters) - The Bank of Canada suggested on Thursday that the changes it makes to interest rates may affect inflation more quickly than previously thought, and that a move away from its current inflation-targeting model could be relatively easy.

<p>The Bank of Canada building is pictured in Ottawa July 30, 2009. REUTERS/Chris Wattie</p>

A research paper published in the Bank of Canada Review analyzes the causes and consequences of Canada’s “low inflation persistence”, a phrase that means the inflation rate responds quickly to changes. The bank used as a metaphor the ability of a speedboat to change direction faster than a massive ocean liner.

In the past, the bank has said it takes 18 to 24 months for interest rate hikes to affect inflation. But that may no longer be the case, its researchers suggest.

“Other things being equal, this means that monetary policy in Canada need not be as forward-looking as it would need to be if persistence was high,” analysts Rhys Mendes and Stephen Murchison wrote in the article.

“It also means that the optimal time horizon over which inflation should return to the target, following a disturbance, is shorter than would otherwise be the case.”

After a brief period of falling prices in Canada last year, the annual inflation rate hit 1.9 percent in January -- almost touching the Bank of Canada’s target of 2 percent.

Yet the bank’s benchmark interest rate is at a historical low of 0.25 percent and policymakers have said they intend to keep it there at least until the end of June to help nurse the economy back to health after a recession.

The article also said inflation behavior in Canada might favor the adoption of a price-level target to replace the Bank of Canada’s inflation target, which it is committed to until the end of 2011 when an agreement with the government expires.

Unlike inflation targeting, which focuses on a two-year horizon, price-level targeting tries to compensate for short-term deviations from a specific numerical target in the consumer price index. For example, if the target has been overshot, the bank would temporarily tighten monetary policy more than would have been warranted otherwise.

“For a central bank considering the relative merits of price-level versus inflation targeting, recent research suggests that low structural persistence in inflation will tend to favor the former,” the article said.

The Bank of Canada is researching both options in preparation for forging its next agreement with Ottawa next year.

Reporting by Louise Egan; editing by Peter Galloway

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