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This聽Hub Dialogue is with Professor Chris Ragan, the founding director of the Max Bell School of Public Policy at 平特五不中.聽聽
Chris has distinguished himself as one of Canada鈥檚 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.聽聽
This conversation has been revised and edited for length and clarity.聽
SEAN SPEER:聽I鈥檓 grateful to speak to Chris as part of聽The Hub鈥檚聽ongoing series of articles and essays on the renewal of the Bank of Canada鈥檚 monetary policy framework. Thanks for joining me.聽
CHRIS RAGAN:聽Thanks for having me.聽聽
SEAN SPEER:聽How does the Bank of Canada鈥檚 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?聽聽
CHRIS RAGAN:聽There鈥檚 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鈥檚 Governor are currently in the middle of figuring out what the next one will be because the new agreement will start in January 2022.聽聽
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鈥檚 ultimate target is two percent per year for CPI inflation, but there鈥檚 a recognition that it cannot control it perfectly鈥攖hat there鈥檚 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.聽聽
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.聽聽
Yet, while that鈥檚 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 鈥渃loset鈥� inflation聽targeter, but Bernanke鈥檚 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.聽聽
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.聽聽
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.聽聽
Have these differences produced different outcomes? That鈥檚 actually pretty hard to say. I think what we have observed, which is often called the 鈥淕reat Moderation鈥�, 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鈥檚 what is meant by the Great Moderation. Yet in the past dozen years, we鈥檝e had the global financial crisis in 2008 and COVID-19 in 2020 and now not many people talk about the Great Moderation anymore.聽
SEAN SPEER:聽What is the significance of the two percent target? Is it a precise number鈥攖hat is, is there something optimal about two percent inflation? Or have we just collectively decided that it鈥檚 the least risky band for monetary policy?聽聽聽
CHRIS RAGAN:聽So, two percent isn鈥檛 a random number. It鈥檚 a fairly precise number. But there鈥檚 nothing magic about two percent.聽聽
When John Crow became the Bank of Canada Governor in the late聽1980s聽he was talking about the drive for so-called 鈥減rice stability.鈥� That鈥檚 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.聽聽聽
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鈥檚 a widespread agreement that there are various economic and social costs associated with higher inflation, so that鈥檚 the argument for not setting your target at four percent or six percent or eight percent.聽聽
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鈥檚 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.聽
There鈥檚 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鈥檚 very difficult to get real wage adjustment in a world of very low inflation.聽
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.聽聽
These debates have been going on for a long time and we鈥檙e still having them today with more or less many of the same arguments. So, in short, there鈥檚 nothing magic about two percent, but in Canada for 25 years, I鈥檇 say two percent has been working pretty darn well.聽
Central bank limitations聽
SEAN SPEER:聽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鈥檚 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?聽
CHRIS RAGAN:聽I鈥檇 like to begin my answer by answering a question that you didn鈥檛 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鈥檚 called the 鈥渄ivine coincidence鈥� of inflation targeting. I鈥檒l come to it in a moment.聽聽
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鈥檛 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.聽聽
One lesson was that high inflation was costly. It鈥檚 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鈥檚 the first lesson.聽聽
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鈥檚 actions really end up determining either the price level or its rate of growth, which is the rate of inflation.聽聽
There was a growing realization that the one thing that central banks really could influence in a sustained way was inflation.聽
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鈥檚 target inflation. Let鈥檚 not target other things because, apparently, we can鈥檛 have a sustained influence on those things. And as long as we鈥檙e going to target inflation, and we recognize that high inflation is a problem, let鈥檚 target low inflation. So, that鈥檚 the simple story that I tell but I think it鈥檚 also accurate for how central banks came to say, 鈥淲e鈥檙e going to target low inflation鈥攖hat鈥檚 going to be our goal.鈥澛犅�
Central to that idea is that we鈥檙e 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鈥檛 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.聽聽
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鈥檙e targeting inflation because we鈥檙e not going to target other things because we can鈥檛 really achieve that, and of course, we鈥檙e targeting low inflation because high inflation is costly.聽聽
So聽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, 鈥淲ell, that was always a bit crazy.鈥� Now, they might not have said that in 1978 because these ideas hadn鈥檛 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.聽聽聽
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鈥檚 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.聽
SEAN SPEER:聽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?聽聽
CHRIS RAGAN:聽It鈥檚 a good question. The level of the consumer price index or its rate of growth, which is inflation, is fundamentally a nominal variable. I鈥檓 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聽labour聽force participation rate. Those are real variables.聽聽
The central bank鈥檚 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鈥檚 nominal money in the economy, or (2) setting the nominal interest rate at the very short end of the yield curve, typically it鈥檚 the target for the 鈥渙vernight rate鈥�, or in the United States, it鈥檚 called the 鈥渇ederal funds rate.鈥� These are nominal instruments. They鈥檙e 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鈥檚 going to end up having an impact on nominal variables.聽聽
Now, what I鈥檓 about to say is still a little bit controversial, but not hugely so. It鈥檚 something that would be signed on to as the conventional wisdom by 95 percent of academic economists and policymakers. It鈥檚 the idea that money and monetary policy is largely neutral in the long run, which is to say that it doesn鈥檛 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.聽聽
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鈥檛 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鈥檚 very much in the ballpark of being true.聽聽
What that tells you is if you鈥檙e targeting an unemployment rate or some other real variable when you鈥檝e got fundamentally one instrument, and it鈥檚 a nominal instrument, you鈥檙e just asking for grief or at least disappointment. That is a key part of the limitations of a central bank.聽
Climate Change聽
SEAN SPEER:聽In addition to your monetary policy expertise, you鈥檙e also a climate policy expert, so I鈥檇 be remiss if I didn鈥檛 ask about calls to account for climate change in general and climate risk in particular in the Bank of Canada鈥檚 mandate. Is this a good idea or a bad idea?聽聽
CHRIS RAGAN:聽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鈥檚 really important that people understand again what the central bank鈥檚 instruments are, and what those instruments are good at dealing with, and what they aren鈥檛 good at dealing with.聽聽
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鈥檚 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鈥檚 mandate.聽聽
I think, for the most part, central banks and climate change should stay away from each other.聽
One big asterisk to this, though, is that the Bank of Canada cares very much about the stability of financial markets. It鈥檚 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.聽聽
Here I think it鈥檚 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鈥檚 no surprise that Mark Carney, when he was the Governor of the Bank of England, gave that famous speech at a Lloyd鈥檚 dinner in 2015 if I鈥檓 not mistaken, and he talked about the need to build climate risks into balance sheets鈥攂oth corporate balance sheets and bank balance sheets鈥攖o 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.聽
The policy instrument that鈥檚 going to apply here, I would argue, is not the central bank鈥檚 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鈥檙e going to be required to reveal their climate risks, that鈥檚 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鈥檚 going to come from a securities regulator, not the Bank of Canada.聽
So, I actually think central banks have to be careful here, because there鈥檚 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鈥檇 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.聽聽
The ideal mandate聽
SEAN SPEER:聽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?聽聽聽
CHRIS RAGAN:聽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 鈥渇lexible inflation targeting.鈥澛犅�
The Bank of Canada currently targets the rate of inflation as we鈥檝e discussed. It does this by basically saying, 鈥澛爁ollowing shocks of various kinds, we鈥檙e going to try and get back to the inflation target. But we鈥檙e going to be flexible in how we get back there.鈥� So, the Governor never says, 鈥淲e鈥檙e going to get back to target within a month,鈥� or 鈥淲e鈥檙e going to return to target within three months.鈥澛營nstead聽he kind of says, 鈥淲e鈥檙e going to get back to target, but we鈥檒l do so gradually.鈥� The advantage of having that clear target is that the expectations of inflation become pretty well-anchored at the bank鈥檚 target. That鈥檚 a testament to how successful the bank has been at targeting inflation over the last 25 years.聽聽
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鈥� implicit expectations for inflation, and they appear to be almost unchanged. This is the financial markets saying, 鈥淵ou know what? There鈥檚 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鈥檙e going to bring it back to a two percent target.鈥� That鈥檚 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鈥檚 the beauty of having a target. But the beauty of having the flexibility is that you don鈥檛 have to take actions that push the economy suddenly back to target.聽聽
This gets back to the notion of a dual mandate. People who advocate a dual mandate say, 鈥淲ell, what we really want is for the central bank to care about unemployment, as well as inflation.鈥� 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, 鈥淐hanges in inflation come from changes in the output gap and changes in unemployment.鈥澛犅�
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鈥檚 productive capacity, but it鈥檚 rising toward productive capacity, he thinks, 鈥淥kay, at some point, that output gap is going to close, and that鈥檚 going to start creating inflationary pressure and that鈥檚 when I鈥檓 going to start raising interest rates.鈥� That鈥檚 exactly what he鈥檚 now saying because that鈥檚 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.聽聽
This brings me back to the 鈥渄ivine coincidence鈥� of inflation targeting. When you are targeting inflation, you are also caring about the output gap and the unemployment rate. If you鈥檙e stabilizing inflation around its target, you鈥檙e also de-facto stabilizing output and employment. That鈥檚 the divine coincidence. It鈥檚 not about higher powers鈥攊t鈥檚 about the way inflation targeting works and the way our economy generates inflationary pressures. So, in response to the person who says, 鈥淲ell, we really need a central bank that cares about the unemployment rate,鈥� I would say, 鈥淣o, you鈥檝e already got one that cares about the unemployment rate.鈥澛犅�
But what you鈥檙e doing explicitly is you鈥檙e saying your target is the thing that we actually believe you can influence in a sustained way. That鈥檚 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鈥檛 need the formal dual mandate.聽聽
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鈥擨 think to great effect. So, I would say leave it alone. Go for five more years.聽
SEAN SPEER:聽Well, Chris, I don鈥檛 know if this has been a divine conversation, but it鈥檚 certainly been a master class on a complex yet important subject. On behalf of聽The Hub鈥檚聽readers, thank you so much for taking the time to speak with us.聽
CHRIS RAGAN:聽Thank you, Sean.聽
About the authors
Christopher Ragan is the founding Director of 平特五不中鈥檚 Max Bell School of Public Policy and is an Associate Professor in 平特五不中鈥檚 Department of Economics.
Ragan was the Chair of Canada鈥檚 Ecofiscal Commission, which launched in November 2014 with a 5-year horizon to identify policy options to improve environmental and economic performance in Canada. He was also a member of the federal finance minister鈥檚 Advisory Council on Economic Growth, which operated from early 2016 to mid 2019. During 2010-12 he was the President of the Ottawa Economics Association. From 2010-13, Ragan held the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, and for many years was a member of the Institute鈥檚 Monetary Policy Council. In 2009-10, Ragan served as the Clifford Clark Visiting Economist at Finance Canada; in 2004-05 he served as Special Advisor to the Governor of the Bank of Canada.
Chris Ragan鈥檚 published research focuses mostly on the conduct of macroeconomic policy. His 2004 book, co-edited with William Watson, is called Is the Debt War Over? In 2007 he published A Canadian Priorities Agenda, co-edited with Jeremy Leonard and France St-Hilaire from the Institute for Research on Public Policy. The Ecofiscal Commission鈥檚 The Way Forward (2015) was awarded the prestigious Doug Purvis Memorial Prize for the best work in Canadian economic policy.
Ragan is an enthusiastic teacher and public communicator. In 2007 he was awarded the Noel Fieldhouse teaching prize at 平特五不中. He is the author of Economics (formerly co-authored with Richard Lipsey), which after sixteen editions is still the most widely used introductory economics textbook in Canada. Ragan also writes frequent columns for newspapers, most often in The Globe and Mail. He teaches in several MBA and Executive MBA programs, including at 平特五不中, EDHEC in France, and in special courses offered by McKinsey & Company. He gives dozens of public speeches every year.
Ragan received his B.A. (Honours) in economics in 1984 from the University of Victoria and his M.A. in economics from Queen鈥檚 University in 1985. He then moved to Cambridge, Massachusetts where he completed his Ph.D. in economics at M.I.T. in 1989.
Sean Speer is a Senior Fellow of the Munk School and project co-director of the School鈥檚 Ontario 360 research project.
Sean is also currently the PPF Scotiabank Fellow for Strategic Competitiveness at the Public Policy Forum and editor at large at The Hub. He previously served as a senior economic adviser to former Prime Minister Stephen Harper.
