1. The liquidity trap, Mankiw’s 9 th principle, and inflation targets: the Bank of Canada dilemma Serge Coulombe Department of Economics University of Ottawa For presentation at 50 th annual meeting of the Canadian Economic Association University of Ottawa, Ottawa, Canada, June 3 rd 2016 1

2. The question on the table is: Should The Bank of Canada Raise The Inflation Target? My answer is No But the actual inflation target should be slightly adjusted 2

3. I have a model: Keynes-Hicks liquidity trap ‘Essentially the whole advanced world, accounting for 70 percent of world GDP at market prices, is in a liquidity trap.’ Paul Krugman march 17 2010 (NYT blog) 3

4. The liquidity trap: conventional monetary policy inefficient The monetary transmission mechanism is broken i Y LM 0 LM 1 IS YnYn 4

5. What are the threats ? The equilibrium nominal interest rate is negative Threats of a prolonged recession, slower growth Falling prices (deflation) is also a threat because it will increase the real interest rate Doubling the quantity of money has no effect on inflation 5

6. Rare occurrence but that last a long time: occurred in the US and elsewhere in the 1930 6

7. Source : Orphanides (2003) Monetary Policy in Deflation: The Liquidity Trap in History and Practice. Miméo, FED 7

8. 8

9. Small comment : Mankiw economic principles and negative interest rates The only thing that matter for the validity of the liquidity trap model is that the short run nominal interest rate is close to the floor. Whether the floor is a hardwood (like the ZLB) or a soft carpet (-0.25 %) does not matter In a liquidity trap, the link between money and inflation is broken. More importantly Mankiw’s principle number 9 (Prices Rise When the Government Prints Too Much Money) is rejected. 9

10. In the actual context the Bank of Canada is not able to increase the inflation rate The BoC has one gun with very few bullets (two?) remaining. Take a Taylor rule: increasing inflation by 2 % requires a decrease of the overnight rate by around 3 %. This is not possible. The BoC should never commit to a target it cannot achieve. Credibility is an asset that could evaporate rapidly. My answer to the question is no because in a liquidity trap the Bank of Canada cannot increase the inflation rate. 10

11. I doubt that the Bank of Canada can control inflation with non traditional monetary policies Quantitative easing and commitment (two non-traditional monetary policies suggested by Keynes to the UK and US central banks in the 1930) are non-traditional monetary policies (When a central bank has exhausted its bullets, it has to use bayonet) The recent experiments of QE suggest limited impacts I don’t think that the BoC can push inflation up to 4 or 5 % by using non traditional monetary policy (Commitment and Quantitative easing) In order to control inflation, a CB needs ammunitions. 11

12. In the 2001, 2006, and 2011 renewals of Inflation target ‘The Bank of Canada sets its policy interest rate so as to keep inflation at 2 per cent, on average, over the medium term. http://www.bankofcanada.ca/wp- content/uploads/2010/11/why_canada_inflation_target.pdf http://www.bankofcanada.ca/wp- content/uploads/2010/11/why_canada_inflation_target.pdf 12

13. Since 2009, the Bank of Canada has not been able to achieve 2 % inflation 13

14. Credibility issue I suggest that the 2 % average over the medium term should be abandoned for the renewal of inflation target. A target of 1 to 3 % is enough. 14

15. In a liquidity trap, the threat is not inflation, it is deflation If credible, targeting a positive inflation might be useful to anchor expectations (avoiding downward pressures on the ex ante real interest rate I think that an inflation target might be a useful tool to avoid deflation Inflation target have been designed initially to help central banks decrease the inflation rate. In the actual situation, the role of inflation targeting is reversed: inflation targets might help increasing inflation (this is not a Mankiw's principle yet). 15

16. Mean (IMF) inflation rates 2011-2015 Inflation TargetsNo Inflation Targets Switzerland-0.37 Sweden0.72Japan0.70 New Zealand1.52Denmark1.38 Canada1.66Germany1.41 United Kingdom2.23Norway1.65 Australia2.27United States1.66 Finland1.92 Mean 1.68 Mean (1.19, without Switz. 1.45) 16

17. In normal circumstance (when Mankiw's principle 9 applies) Raising the inflation target might be a way to avoid falling back in a trap. Many other costs however are associated with higher inflation (4 to 5%). I am particularly concerned regarding the possibility that the CAD becomes a Northern Peso (a continually depreciating CAD with respect to the US dollar will increase cost of trading with our principle partner) 17

18. Conclusion: in the meantime we don't live in normal circumstances. Even in this abnormal circumstances, a central bank should never commit to an outcome it cannot achieve. Losing credibility will endanger the capacity of the Bank of Canada to anchor expectations with the inflation target rule. I also think that the Bank of Canada should not commit to keep the inflation rate around 2% on average. 1 to 3 % is enough. It will also provide more flexibility to the Bank to adjust if, by any chance, the economy get out of the trap during the next mandate (keeping inflation in the 2 to 3% range for example). This is not possible in a world where Mankiw’s principle 9 does not apply. 18