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Inflation-Control Target

Inflation targeting has been the cornerstone of monetary policy in Canada since 1991.

The initial objective of the joint agreement between the Government of Canada and the Bank of Canada was to reduce inflation, as measured by the total consumer price index (CPI) from a rate of about 5 per cent in late 1990 to 2 per cent by the end of 1995.

With inflation coming down well ahead of schedule, the focus at the 1993 renewal of the agreement then shifted towards keeping it low, stable, and predictable at an annual rate of 2 per cent – the midpoint of a control range of 1 to 3 per cent.

The inflation-control target has been extended four times since 1991 – in 1993, 1998, 2001, and in 2006 to the end of 2011.

The inflation-targeting approach to monetary policy

The inflation-control target guides the Bank in determining the monetary policy actions that are required to maintain a stable price environment over the medium term.

To achieve the inflation target, the Bank of Canada adjusts its policy interest rate (the overnight rate), which then influences other interest rates in the economy.

When demand is too strong, pushing the economy against its capacity limits, and there is a risk that future inflation will move appreciably above the 2 per cent target, the Bank will raise its policy rate to cool down the economy.

When demand is weak, and future inflation pressures are likely to ease, the Bank will lower its policy rate to stimulate the economy, absorb spare production capacity, and return inflation to 2 per cent.

The Bank thus views the risks of inflation moving above or below the target with equal concern and acts symmetrically to avoid both risks over the medium term. Such an approach guards against both high inflation and persistent deflation.

A credible monetary policy based on a forward-looking framework of inflation targeting, as just described, acts as an automatic stabilizer for economic activity. In this sense, inflation targeting has helped the Canadian economy to avoid the painful boom-and-bust cycles of the past and to absorb shocks more effectively.

Other advantages of inflation targeting

Inflation targeting has helped to make the Bank's monetary policy actions better understood by financial markets and the public. And an explicit inflation target has provided a clear yardstick for evaluating the effectiveness of monetary policy.

Success in reducing inflation, coupled with a firm commitment to keep inflation low through time, has also helped to anchor inflation expectations around 2 per cent. Well-anchored inflation expectations have allowed businesses and households to take a longer view in their planning, which has led to a better allocation of economic and financial resources and a more stable economy overall.