Transparency and the Bank of Canada

This article was pretty interesting. At Bank of Canada, a debate on revealing less - The Globe and Mail

There are two comments I'd like to make, one about transparency and one about price-level targeting.


From the article.
There is an emerging opinion that central banks contributed to the financial crisis by making their intentions for interest rates too predictable. The best example is the U.S. Federal Reserve, which, under former chairman Alan Greenspan, raised its benchmark interest rate in 17 quarter-point increments starting in June, 2004, and ending with the Fed funds rate at 5.25 per cent in June, 2006.

The worry - it must be said, in retrospect - is that too much transparency causes investors to become complacent.

Thinking they have the central bank's interest-rate path figured out, investors put less effort into assessing economic fundamentals. This creates a kind of groupthink that removes an important check on exuberant behaviour: skepticism.

In 1996, Greenspan spoke about "irrational exuberance". "Irrational exuberance" would imply tightening ahead, and so it appears that Greenspan was very transparent of his intentions. Yet the market ignored this, and the Nasdaq went on to inflate and burst.

Could it be that what Fed does is much more important than what the chairman would say? Apparently not, according to emerging opinion.

The second point is about price-level targeting. As I have showed in previous post, the Bank of Canada has little effect on inflation, and what areas it does have an effect on, it is doing a poor job. So what price-level targeting do to the Canadian economy? It would only exacerbate any problems.

I work under a simple premise, that if the interest rate set by the Bank of Canada is lower than the interest rate that would be set by the market, then you have malinvestment, and malinvestment is bad and will eventually need to be cleansed from the economy. The most recent examples were the housing bubble and the Nasdaq bubble in the US. The 1% interest rate in the US, which would be below any reasonable estimate of a market interest rate, caused investors to act under false pretenses. Low interest rates should mean that there is a large amount of capital available (ie. people have so much money that they are willing to lend it out at 1%), but of course this was not the case, there was not an abundance of capital. Central banks misled investors by lowering interest rates to such levels.

So why will price-level targeting exacerbate problems in Canada? Well Canada currently has a CPI of 1.9%, lower than their target of 2%. Well if China's over-capacity allows them to sell us goods for lower prices, then Canada's CPI will be below 2% for the foreseeable future. This would mean that the Bank of Canada could keep rates at near zero, and will snowball the malinvestments. With a price target of 2%, you could simply ignore the year and look forward, but with price-level targeting, you will need to keep the interest rate at an artificially low level which of course would increase the amount of malinvestment. (And the more malinvestment, the worse the recession/depression will be)

Well, if the Chinese decide to pass on their inflation to Canada, our CPI could easily go up to 3%, and stay there. That means that for the foreseeable future, the Bank would continually increase its interest rates to fight a fire that it has very little control over. Again, price-level targeting, would mean the BOC will need to continually increase the interest rate to get the average to 2%. And this of course will cause the currency to appreciate, and destroy the economy.

Now if the BOC was really serious about price-level targeting (It would be really nice if the target was 0!!), it should first look seriously at how it calculates CPI and base the price-level targeting on only this items that it actually has control over (perhaps just services?).