Is inflation a tax? A question to Mark Carney

On February 10, 2009, the governor of the Bank of Canada, Mr Mark Carney, appeared before the Standing Committee on Finance, on which I sit, to discuss the state of the economies of Canada and the rest of the world. I asked him a question on the nature of inflation and the inflation target of the Bank of Canada. You can watch this exchange (in English) on the following video clip or read the adapted transcript below. — 21 April 2009

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Maxime Bernier: You said in a speech two weeks ago in Halifax, and I quote:

… monetary policy is concerned with how much money circulates in the economy, and what that money is worth. The single, most direct contribution that monetary policy can make to sound economic performance is to provide Canadians with confidence that their money will retain its purchasing power.

At the same time, you spoke about the inflation target of 2%, which you called the cornerstone of the bank’s monetary policy framework.

I’m wondering how money can retain its purchasing power when it loses it by 2% every year. An inflation rate of 2% per year may seem small, but ultimately when you add up 2% depreciation of the monetary unit year after year, you end up with big numbers.

I went to the Bank of Canada website and I used the inflation calculator you provide there to see how much value our dollar has lost over the past few years. Let’s take 1990 as a reference point. It is not that long ago, but from 1990 to today, inflation in Canada adds up to 42%. This means that our dollar can now buy the equivalent of only 70¢ compared to 19 years ago.

The fundamental cause of price inflation is that the money supply is continually increasing. We get price inflation because we first have monetary inflation. The more money there is, the more likely it is that overall prices rise and that our dollar will lose its purchasing power.

I also saw on your website that M1, which is one definition of the monetary supply, has increased by 6% to 12% annually over the past 12 years. That’s a lot more than the growth rate of our economy. This inflation eats away at the income of every Canadian and it reduces the value of their savings. When your colleague at the Federal Reserve, Mr. Bernanke, appeared before a congressional committee on July 16, 2008, he said that inflation is a tax because people are forced to pay more for the goods and services they buy.

I would like to ask you two questions. The first is whether you agree with the chairman of the Federal Reserve that inflation is a tax. My second question has to do with the 2% inflation target. This implies a very large depreciation of our currency over the years. I wonder why the target is 2% and not a 0% target that will allow a complete preservation of the dollar’s purchasing power. I understand that this target is fixed in agreement with the finance department and that you cannot simply decide to change it on your own, but I would like to have your opinion. As an economist, do you think a 0% inflation target would have more advantages, and if not, why not?

Mark Carney: You’ve been busy, Monsieur Bernier!

I’ll mention a couple of things very rapidly; we can have a deeper discussion later.

First, as you referenced, there’s a very clear accountability framework for the Bank of Canada. The 2% inflation target is an agreement with the Government of Canada. It runs through 2011, and I would say that since the inception of that agreement in the early 1990s, inflation in Canada, as it’s tracked, has averaged exactly on that 2%. So the agreement has been fulfilled. It’s important in times like this, where there are some disinflationary pressures, that Canadians have the confidence that inflation will be at that. Those expectations remain.

Let me make a very important point in the current environment. The fact that Canadians can expect, in the medium term, that inflation will be at 2% helps to bring negative real interest rates at very low interest rates at the moment. But I absolutely agree that your calculations are correct: they’re based on our calculator, so they’d better be correct. This is a political economy decision. We’re doing a lot of research on this, whether it would be better to have a lower target. We will come back to this committee to discuss that research at the appropriate time.

You used depreciation of the currency, and the one thing I want to flag on that is that what is relevant for exports and competitiveness is the real effective exchange rate, which is a product of where the actual headline nominal exchange rate is, and relative inflation rates in countries. So it matters what the inflation rate is in, say, the U. S. relative to Canada.

The last point I’d like to make is on M1 growth in Canada. What’s important in this time of crisis–and always important–is the relationship between the narrow monetary aggregates and the broader monetary aggregates. What you’re seeing in a variety of other countries is that the velocity of money has shrunk and so the broader monetary aggregates–the credit aggregates–are not growing, even though the monetary base is growing. The issue is to repair those linkages in Canada. You still have a more stable relationship and it’s relevant to Monsieur Mulcair’s question in terms of the medium term.

My last point is that one thing that has turned in the last month or so is that M1 growth is now above nominal GDP growth globally, which is normally a precursor of expansion.