Today’s Hub Dialogue is with Professor Chris Ragan, the founding director of the Max Bell School of Public Policy at McGill University.
Chris has distinguished himself as one of Canada’s leading economists on a wide range of topics ranging from public finance, carbon taxes, and monetary policy. One of his greatest strengths is communicating complex economic issues and concepts in simple terms.
This conversation has been revised and edited for length and clarity.
SEAN SPEER: I’m grateful to speak to Chris as part of The Hub’s ongoing series of articles and essays on the renewal of the Bank of Canada’s monetary policy framework. Thanks for joining me.
CHRIS RAGAN: Thanks for having me.
SEAN SPEER: How does the Bank of Canada’s current mandate compare to the Federal Reserve? Is it more or less narrowly focused on inflation? And if it differs, how did these differences evolve, and have they led to different outcomes?
CHRIS RAGAN: There’s a lot there. Let me begin with the Bank of Canada. The Bank of Canada has operated according to agreements between the bank and the Government of Canada since 1991. These agreements are typically five years in duration. As you know, the Minister of Finance and the Bank of Canada’s Governor are currently in the middle of figuring out what the next one will be because the new agreement will start in January 2022.
These agreements since 1991 have been about how the Bank of Canada should target the rate of inflation. Since 1995, that target has been an inflation rate of two percent with an operating band between one and three percent. What that means is the bank’s ultimate target is two percent per year for CPI inflation, but there’s a recognition that it cannot control it perfectly—that there’s going to be some volatility and that fluctuations between one and three percent are okay. Deviations of inflation outside that band are implicitly viewed as more serious.
The Federal Reserve, by contrast, since the Humphrey-Hawkins legislation of 1978, has explicitly had a dual mandate. That is to say that the U.S. central bank is mandated to both maintain price stability and maximum employment.
Yet, while that’s the statutory mandate, in the early to mid-2000s, then-Federal Reserve chair Ben Bernanke basically announced, without passing any new legislation, that the Federal Reserve would start having an inflation target. There had been discussion before this that the Federal Reserve had been a “closet” inflation targeter, but Bernanke’s statement made it much more explicit. In so doing, he signaled the Federal Reserve would start targeting inflation at two percent like many other central banks.
Canada, incidentally, was the second central bank to adopt inflation targeting, in 1991, preceded only by New Zealand. But since that time many central banks have adopted inflation targeting.
The upshot is that while the Bank of Canada and the Federal Reserve have different legislative mandates, due to the Humphrey-Hawkins Act which gives the Federal Reserve a dual mandate, in practice both have essentially followed an inflation target since the mid-2000s.
Have these differences produced different outcomes? That’s actually pretty hard to say. I think what we have observed, which is often called the “Great Moderation”, is not just a phenomenon for Canada or for the United States, but more generally, across the advanced economies. What we have seen is a clear reduction in inflation from the 1970s, where it was both high and volatile. Inflation has since that time been much lower and much more stable, but also business cycle fluctuations have been less pronounced. That’s what is meant by the Great Moderation. Yet in the past dozen years, we’ve had the global financial crisis in 2008 and COVID-19 in 2020 and now not many people talk about the Great Moderation anymore.
SEAN SPEER: What is the significance of the two percent target? Is it a precise number—that is, is there something optimal about two percent inflation? Or have we just collectively decided that it’s the least risky band for monetary policy?
CHRIS RAGAN: So, two percent isn’t a random number. It’s a fairly precise number. But there’s nothing magic about two percent.
When John Crow became the Bank of Canada Governor in the late 1980s he was talking about the drive for so-called “price stability.” That’s a key expression here. If you take price stability literally, you mean stability in the consumer price index and that would presumably mean zero percent inflation. The notion of price stability was used very loosely in the late 1980s. Then you get to this debate about if we are going to target inflation, is it going to be zero? Or one percent? Or two percent? Or minus one percent? There has been this debate since the early 1990s and it persists today.
When we held our conference at the Max Bell School in Fall 2020, we talked about different options, including ones that deviated from the current status quo. We talked, for instance, about the option of raising the inflation target to three percent or lowering it to one percent or ultimately maintaining the inflation target at two percent. Economists still debate this question. There’s a widespread agreement that there are various economic and social costs associated with higher inflation, so that’s the argument for not setting your target at four percent or six percent or eight percent.
But there are also concerns about having too low a rate of inflation, partly because of what is called the zero or the effective lower bound. If nominal interest rates have a really hard time going below zero, then there’s a danger associated with targeting too low a rate of inflation because doing so means that the central bank has little ability to stimulate the economy (through interest rate cuts) the next time a recession is looming.
There’s also the notion that nominal wages have a hard time falling, which goes back to John Maynard Keynes, and even before where if nominal wages are unlikely to fall, then it’s very difficult to get real wage adjustment in a world of very low inflation.
Most central banks ended up, in the early to mid-1990s, picking two percent or pretty close to a two percent target, because it was low enough to avoid the big costs of higher inflation but it was high enough to avoid this other problem.
These debates have been going on for a long time and we’re still having them today with more or less many of the same arguments. So, in short, there’s nothing magic about two percent, but in Canada for 25 years, I’d say two percent has been working pretty darn well.
Central bank limitations
SEAN SPEER: You previously referred to the idea of a dual mandate which has become part of the debate as the government considers the renewal of the Bank of Canada’s current mandate. Can you please elaborate on what a dual mandate is, how it works, and what happens if the different mandates are in tension?
CHRIS RAGAN: I’d like to begin my answer by answering a question that you didn’t ask: why are we targeting inflation at all? How did central banks get to the point where they decided to target inflation rather than something else? Part of this answer is going to introduce what’s called the “divine coincidence” of inflation targeting. I’ll come to it in a moment.
If you think about what happened in the three decades of the 1960s, 1970s, and 1980s, there was a lot of learning by academic economists and policymakers in central banks. The high and volatile inflation during the 1970s was partly caused by the oil shocks caused by OPEC, but it was also partly caused by central banks that didn’t quite know what kind of shocks had hit them and how to respond. There were a lot of mistakes made, and I would say there are two fundamental lessons that economists and central bankers learned over that time.
One lesson was that high inflation was costly. It’s costly in a lot of ways, and high inflation tends to be volatile. Both high and volatile inflation are very costly, not just for individuals, but for the economy as a whole. They get in the way of investment; they get in the way of growth; they get in the way of the efficient operating of the price system. So that’s the first lesson.
The second lesson was a more subtle lesson. There was a growing realization that the one thing that central banks really could influence in a sustained way was inflation. I mean, central bank policy can influence many variables over a short period of time. But there was this growing recognition that after all the dust settles, the central bank’s actions really end up determining either the price level or its rate of growth, which is the rate of inflation.
It took central bankers about 30 years to come to these insights, but once you get your head around those two lessons, you come rather quickly to the conclusion that if inflation is the only thing that we can really influence on a sustained basis, then let’s target inflation. Let’s not target other things because, apparently, we can’t have a sustained influence on those things. And as long as we’re going to target inflation, and we recognize that high inflation is a problem, let’s target low inflation. So, that’s the simple story that I tell but I think it’s also accurate for how central banks came to say, “We’re going to target low inflation—that’s going to be our goal.”
Central to that idea is that we’re not going to target other things that we cannot influence in a sustained, long-run way. There was a growing recognition, for instance, that we couldn’t really have a very predictable and sustained influence on real GDP growth or the unemployment rate, or the path of real wages, or on investment as a share of GDP. Those are real variables that monetary policy has a really hard time driving or influencing in a predictable way for any length of time beyond a couple of years.
So, when you absorb all of that in your head, you get to the point where we are now, which is the standard view among central banks: we’re targeting inflation because we’re not going to target other things because we can’t really achieve that, and of course, we’re targeting low inflation because high inflation is costly.
So this now comes back to your question about a dual mandate. Many economists look at the Federal Reserve with a dual mandate from the Humphrey-Hawkins legislation and say, “Well, that was always a bit crazy.” Now, they might not have said that in 1978 because these ideas hadn’t really fully been absorbed then but by 1996 or 2006 economists were increasing thinking it was kind of crazy. Then of course Bernanke came out in the mid-2000s and signals that the Federal Reserve will now start to target inflation.
My interpretation is that he was, like the terrific economist that he is, recognizing that central banks really had significant limitations. And I want to come back to that notion of central bank limitations because when you ask about new and different mandates for central banks, I think there’s far too little recognition today in public discourse about the limitations of central banks. And in my view, the idea of having an inflation target, rather than any other target, including a dual mandate, is fundamentally a recognition of the limitations of a central bank.
SEAN SPEER: What is it about inflation that makes it more prone to a causal relationship with a particular policy tool relative to some of these other economic issues (say real GDP growth or business investment) that are less prone to a single policy tool?
CHRIS RAGAN: It’s a good question. The level of the consumer price index or its rate of growth, which is inflation, is fundamentally a nominal variable. I’m making the important distinction between a nominal variable and a real variable: a nominal variable is one that has value or its meaning in terms of dollars and a real variable is one that has meaning in terms of units of output. Think for instance of the share of investment in the economy, the unemployment rate, or the labour force participation rate. Those are real variables.
The central bank’s policy instrument is a nominal policy instrument. You can think about it in two ways. You can think about it as (1) setting the amount of money in the economy, and that’s nominal money in the economy, or (2) setting the nominal interest rate at the very short end of the yield curve, typically it’s the target for the “overnight rate”, or in the United States, it’s called the “federal funds rate.” These are nominal instruments. They’re about the amount of money in the economy, or about the nominal interest rate. The key fact here on your question about causality is that, if you have a nominal instrument it’s going to end up having an impact on nominal variables.
Now, what I’m about to say is still a little bit controversial, but not hugely so. It’s something that would be signed on to as the conventional wisdom by 95 percent of academic economists and policymakers. It’s the idea that money and monetary policy is largely neutral in the long run, which is to say that it doesn’t have any or much long-run impact on real variables; it has its long-run impact mostly on nominal variables. So, it will influence the price level and it will drive the rate of growth of the price level. But the nature of monetary policy as a nominal instrument is that it ends up having its impact almost exclusively on nominal variables in the long run.
This idea is absolutely conventional wisdom today among macroeconomists, but it was more controversial until economists like Milton Friedman and others, in the late 1960s, started really advancing this idea, and pushing the profession to recognize the importance of what we call long-run money neutrality. And we don’t have to get hung up on whether money is exactly neutral or only mostly neutral. Most of our macroeconomic models embody this notion of long-run money neutrality, and most economists would say it’s very much in the ballpark of being true.
What that tells you is if you’re targeting an unemployment rate or some other real variable when you’ve got fundamentally one instrument, and it’s a nominal instrument, you’re just asking for grief or at least disappointment. That is a key part of the limitations of a central bank.
SEAN SPEER: In addition to your monetary policy expertise, you’re also a climate policy expert, so I’d be remiss if I didn’t ask about calls to account for climate change in general and climate risk in particular in the Bank of Canada’s mandate. Is this a good idea or a bad idea?
CHRIS RAGAN: Let me try two different parts to this answer. I care deeply about climate change, so none of this is trying to avoid dealing with climate change. But I do think it’s really important that people understand again what the central bank’s instruments are, and what those instruments are good at dealing with, and what they aren’t good at dealing with.
I think, for the most part, central banks and climate change should stay away from each other. What I mean by that is, if you take the view that the central bank has to worry about inflation, and its policy instrument is uniquely designed to deal with inflation, then, if climate change affects inflation or the inflation process, it’s fine for the central bank to build that into its models. But I think the idea that a central bank would have a mandate that includes climate change, or for that matter includes any other real variable that is not very closely tied to its policy instrument, is a mistake. I would keep climate change out of the bank’s mandate.
One big asterisk to this, though, is that the Bank of Canada cares very much about the stability of financial markets. It’s not just inflation. The bank cares about the stability and the functioning of financial markets, because its policies have their impact through financial markets, and financial markets are important more generally for the smooth functioning of the economy.
Here I think it’s appropriate for the Bank of Canada and other central banks to be talking about the importance of building climate risks into the financial markets. It’s no surprise that Mark Carney, when he was the Governor of the Bank of England, gave that famous speech at a Lloyd’s dinner in 2015 if I’m not mistaken, and he talked about the need to build climate risks into balance sheets—both corporate balance sheets and bank balance sheets—to recognize financial risks stemming from climate change similar to how you recognize non-climate risks. You want financial institutions to recognize these risks; you want the financial capital to then flow appropriately away from risky things and toward less risky things, and in this context away from high carbon things and toward low carbon things. I think all of that is very appropriate.
The policy instrument that’s going to apply here, I would argue, is not the central bank’s policy instrument. Tiff Macklem may talk about the importance of the financial markets and financial institutions to think about climate risks but ultimately regulations along these lines will need to come from regulators. If you want to think about what regulations the banks are going to face such as slightly different capital ratios, or if they’re going to be required to reveal their climate risks, that’s probably going to be an OSFI regulation. It might be regulations on publicly-traded companies, and whether they are going to be required to monitor and log their climate risks, and that’s going to come from a securities regulator, not the Bank of Canada.
So, I actually think central banks have to be careful here, because there’s a general danger that whenever a central banker stands up and talks about problem X, Y, or Z, people will come to believe that they have an instrument that can deal with problem X, Y, or Z. As a general rule, then, you want to be very careful to ensure that if you are going to talk about a specific problem, you also draw the connection between that problem and your fundamental mandate. And if your fundamental mandate is to keep inflation low and stable, then you’d better explain to us why problem X, Y, or Z affects that mandate. Otherwise, be careful about going down that rabbit hole because there is a real danger that you will confuse people about what your instrument can do and cannot do.
The ideal mandate
SEAN SPEER: If you were the Minister of Finance renewing the mandate with the current Bank of Canada Governor, what mandate would you grant him at the bank?
CHRIS RAGAN: I think the mandate would look a lot like the current mandate. As part of my answer though let me say a little bit about not just inflation targeting but what we call “flexible inflation targeting.”
The Bank of Canada currently targets the rate of inflation as we’ve discussed. It does this by basically saying, ” following shocks of various kinds, we’re going to try and get back to the inflation target. But we’re going to be flexible in how we get back there.” So, the Governor never says, “We’re going to get back to target within a month,” or “We’re going to return to target within three months.” Instead he kind of says, “We’re going to get back to target, but we’ll do so gradually.” The advantage of having that clear target is that the expectations of inflation become pretty well-anchored at the bank’s target. That’s a testament to how successful the bank has been at targeting inflation over the last 25 years.
So, when you get hit with a big shock, and this was true, by the way, right after the financial crisis as well as in the context of COVID-19, you look at the financial markets’ implicit expectations for inflation, and they appear to be almost unchanged. This is the financial markets saying, “You know what? There’s a big honking shock out there today, but we trust that the central bank is going to bring it back. It may not be right away, but fairly soon. Within a couple of years, they’re going to bring it back to a two percent target.” That’s huge because a big part of keeping inflation close to the target is having inflation expectations that never deviate very far away from the target. That’s the beauty of having a target. But the beauty of having the flexibility is that you don’t have to take actions that push the economy suddenly back to target.
This gets back to the notion of a dual mandate. People who advocate a dual mandate say, “Well, what we really want is for the central bank to care about unemployment, as well as inflation.” And my response to that is, show me a central banker who targets inflation as their explicit mandate and I will show you a central banker who cares about the unemployment rate, because they all do, precisely because the model of the economy that is in their minds is very much a model that says, “Changes in inflation come from changes in the output gap and changes in unemployment.”
So, Tiff Macklem probably has a beautiful graph in real-time of the output gap above his desk. And when he sees the output gap start to close, where output is below the economy’s productive capacity, but it’s rising toward productive capacity, he thinks, “Okay, at some point, that output gap is going to close, and that’s going to start creating inflationary pressure and that’s when I’m going to start raising interest rates.” That’s exactly what he’s now saying because that’s what he sees happening. And, he has been saying this very clearly over the past 18 months. His message that interests rates will stay low until the economy recovers is a statement about real output and the unemployment rate.
This brings me back to the “divine coincidence” of inflation targeting. When you are targeting inflation, you are also caring about the output gap and the unemployment rate. If you’re stabilizing inflation around its target, you’re also de-facto stabilizing output and employment. That’s the divine coincidence. It’s not about higher powers—it’s about the way inflation targeting works and the way our economy generates inflationary pressures. So, in response to the person who says, “Well, we really need a central bank that cares about the unemployment rate,” I would say, “No, you’ve already got one that cares about the unemployment rate.”
But what you’re doing explicitly is you’re saying your target is the thing that we actually believe you can influence in a sustained way. That’s inflation. So, keep the explicit target the way it is, but that flexibility gives the central bank the ability to take advantage of that divine coincidence, and then, you don’t need the formal dual mandate.
I would say the status quo has been working bloody well for 25 years, and that this flexibility gives you a lot of wiggle room that the central banks have used—I think to great effect. So, I would say leave it alone. Go for five more years.
SEAN SPEER: Well, Chris, I don’t know if this has been a divine conversation, but it’s certainly been a master class on a complex yet important subject. On behalf of The Hub’s readers, thank you so much for taking the time to speak with us.
CHRIS RAGAN: Thank you, Sean.