Stephen Poloz may let inflation creep higher: Don Pittis

Which would you prefer, higher interest rates or higher inflation?

If you are someone who actually watches what the Bank of Canada does month to month, its two per cent inflation target mayseemsacrosanct.

In which case, you might be surprised to hear thatthe conceptof raising or lowering interest rates to freeze inflation at exactly two per cent is a relatively recent innovation. It was put in place in reaction to the soaring prices and wagesof the 1970s and 1980s.

And the Bank of Canada has been seriously considering changing that target. Any change would still require a new agreement between the federal government and the bank. The current agreement is scheduled to end next year.

A freshreport from the business news service Bloombergimpliesthat the bankcould surprise us with just such an announcement any time soon. [See clarification below].

"After shocking markets with an interest rate cut in January," wrote Bloomberg'sGreg Quinn, "Bank of Canada Governor Stephen Poloz is considering whether to deliver another surprise: changing the central bank's twoper centinflationtarget."

'No surprise'

Quinn does not offer the source for his latest story, but he follows the bank's activities assiduously. The Bank of Canada, on the other hand, was quick to play down the story.

"It is absolutely wrong to characterize research done by the bank on the implications of a higher inflation target as a surprise," said an official bank spokespersonin response to my inquiry as to whether the Bloomberg story was true.

While research on the subject is definitely not asurprise -- sincelast November the bank has informed Canadians they are studying the issue --an imminent announcement by the Bank of Canada would indeed be a shocker.

And the impact on Canadians couldbe significant.

Raising the inflationtarget is by no meanssome mad idea out of the blue. As recently as June 2014, a workingpaper published by theInternational Monetary Fund,The case for a long-run inflation target of four per cent, made the casethat central banktargets should rise.

Zero bound

"A four percent target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe," says a description of the essay, which the IMF says is by no means IMFpolicy."This benefit would come at minimal cost, because four per cent inflation does not harm an economy significantly."

That "zero bound" reference refers to the difficulty many central banks are facing now. In order to hold inflationdown to twoper cent,the key rates set by banks are effectively as low as they can go, bumping up against zero. Lowering rates into the negative, tried some places in Europe,just encourages saversto hoard cash.

• Central banks can't rescue us from wobbly world markets
• Low rates mean central bankers can't fix the economy

But besides solving the zero bound problem at some point in the future, raising the target rate would have an impact now. And different people would be affected differently.

In the short term, an increase in the target rate would mean Poloz would be in no rush to raise rates if the increase in the cost of livingbegan to creep up. That means if higher oil prices continue to rise over the summer, for example,leadingto increases in the cost of fuel and shipping feeding through to food and other goodsinterest rates would remainat current lows.

At first blush, that sound good, especially for the sake of the short-term economy.Businesses and homeowners could continue to borrow and spend. The housing market would continue to surge, especiallyin Toronto and Vancouver.

Slamming the brakes

But ifinflation began to rush up toward the new target, eventually the central bank would have to slam on the brakes with even higher interest rates than they might have otherwise.

• The interest rate danger of runaway inflation

If four per cent inflation were to become the new normal, there would be other effects as well -- many of them not so clear. Cash savings would fall in value asmoney boughtfour per cent less each year.Wage earners would clamour for higher pay. Banks and other lenders would have to re-examine real asset values.

Because of all those uncertainties, Poloz and his advisers will study the issue very carefully before making any such announcement.

As the Bank of Canada spokespersonsaid:"In all of our communications on possible adjustments to the inflation target, we have been careful to note that the bar for changing the agreement is high."

Which would only make such an announcement, if it were to happen, even more of a surprise.