The Bank of Canada today released a background paper that describes Canada’s experience with inflation targeting, reports on some key issues bearing on the framework for conducting monetary policy, and identifies issues warranting further research.

The release follows the November 23 announcement by the Government of Canada and the Bank of Canada that the inflation-control target has been renewed for a period of five years to the end of 2011.

Under the agreement, the Bank will continue to conduct monetary policy aimed at keeping inflation, as measured by the consumer price index (CPI), at 2%, with a control range of 1% to 3% around this target.

Since Canada adopted inflation targets in 1991, total CPI inflation has averaged very close to 2%, and the variability of inflation has been significantly lower than was the case in the 15 years before inflation targeting. Success in reducing inflation, coupled with an explicit commitment to keep inflation low, stable, and predictable through time, has helped to anchor inflation expectations to the 2% target. A low-inflation environment has contributed to sound economic performance and the well-being of Canadians in a number of important ways.

The inflation target will continue to be set in terms of the 12-month increase in the total consumer price index. Total CPI inflation, however, is subject to considerable variability and so is not always the best indicator of the underlying trend in inflation and, therefore, of where inflation is likely to be in the future. For this reason, core inflation (CPIX) — which removes eight of the most volatile components of total CPI –provides a useful guide for the conduct of monetary policy. In the context of the new inflation agreement, the Bank intends to continue using CPIX as its preferred measure of core inflation..

Based on recent research, the Bank has concluded that the present policy of bringing inflation back to the 2% target within six to eight quarters (18 to 24 months) is still appropriate generally.

It remains the Bank’s view that no explicit recognition should be given to asset prices in the inflation-target index, beyond the recognition already accorded the price of housing services in the CPI. The Bank will focus on the inflation and output consequences of any economic disturbance, including asset-price shocks, and will continue to respond in a manner consistent with meeting its long-run inflation objective. However, as noted above, some flexibility might be required with regard to the time horizon over which the target is achieved. This might involve sacrificing something in terms of inflation performance over the usual horizon, but could lead to greater financial, economic, and inflation stability over a somewhat longer horizon.

While Canada’s 15 years of experience with inflation targeting have been very positive, there remains the question of whether the specific regime established in the 1990s will deliver the greatest contribution to economic performance and to the well-being of Canadians in the decades ahead. With this in mind, the Bank plans to lead a concerted research program to learn from our experience and the experience of others, and to examine whether and how the monetary policy framework in Canada might be improved.

The research program will focus on the potential costs and benefits of targeting a lower rate of inflation or of pursuing a price-level target instead of an inflation target.

The goal is to complete this research well in advance of the next renewal date in 2011 so as to ensure sufficient time for open discussion of the results and their implications.