Most central banks across the world agree that price stability is a critical factor in monetary policy. On this note, the Bank of Canada also has its inflation targets that average 2% on a long term basis. However, the reason most central banks across the world do not aim for zero inflation is because the official price indices normally overstate the actual inflation. This situation often arises because of lack of efforts to improve the quality of products. In most cases, inflation often distorts price signals and result in a misallocation of resources. For instance, there is always confusion concerning a surge in inflation. Citizens lack understanding regarding whether a surge in price is caused by inflation or because of an increased demand for products. In essence, a rise in inflation rates impacts negatively on economic growth (Santos, 2012).
The main objective with regard to monetary policy in Canada is to maintain confidence in the currency by reducing the inflation rate. The question that often emerges concerning reducing inflation in Canada is why maintain it at 2% and not zero. This is because; zero inflation means that, prices remain unchanged over time. Looking at the background of inflation targeting in Canada, both the Federal Government and the Bank of Canada reached a consensus to embrace inflation targets. The main aim in this sense was to reduce inflation through a gradual process. Later, both the Government and the Bank of Canada agreed to maintain the inflation rate at 2% because; it realized success in terms of improved economic performance. At the moment, the Canada is not comfortable with a zero inflation target because, the monetary authorities may lose the opportunity to stimulate the country’s economy using negative real interest rates. On the same not, the real interest rates are not supposed to drop below zero. In most economies, the emphasis on policy option associated with negative real interest rates is often viewed as resulting in an inflation target considered to be appropriate (Santos, 2012).
On the other hand, the Bank of Canada should aim for a moderate amount associated with inflation instead of zero inflation. This is because, is impossible for interest rates to drop below zero, and it is also difficult to accurately measure inflation. Furthermore, there are downward rigidities that tend to interfere with labour market adjustment. Similarly, the reason the inflation rate cannot be reduced to zero is that it interferes with the central bank’s ability to use its normal policy interest rate. In addition, a zero inflation rate will interfere with policies necessary to stimulate the economy because; it is unconventional for the actual interest rates that banks charge to be negative. Conversely, higher inflation target, for instance, 5% is also not advisable. When an inflation target is high, it increases uncertainties and volatility which eventually affects the credibility of the central bank. As such, credibility can be sustained by reducing the inflation rate to a manageable level of 2% in cases where it was raised to about 5% (Willard, 2012).
Therefore, what the Bank of Canada can do next year is to avoid aiming for higher inflation rates. The central bank can use other alternatives that can stimulate economic growth in exceptional circumstances. This helps to avoid the tendency of monetary policy depending on negative interest rates to propel the economy in times of crisis. On another note, because the expectations regarding inflation are critical in any economy, the Bank of Canada should improve its monitoring structures. Indicators for inflation expectations are important to monitor because, they help to anticipate future inflation rate. The Bank of Canada should also maintain a focus in monitoring various economic agents such as financial markets and households (Willard, 2013).
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