BoC says path to 2 per cent inflation will be longer than expected: Why is there a target?

The Bank of Canada has raised its key interest rate again in an effort to bring down inflation, which remains above its target of two per cent year-over-year.

The bank on Wednesday announced that it would raise the overnight rate by 25 basis points to five per cent, the highest it’s been since 2001. One basis point is equal to one-hundredth of a percentage point.

This is the bank’s 10th rate increase since March 2022, with inflation dropping from a peak of 8.1 per cent last summer to 3.4 per cent in May.

Now, the bank predicts that inflation will remain around three per cent over the coming year and won’t reach two per cent until mid-2025, two fiscal quarters later than projected.

WHAT IS THE INFLATION TARGET?

The Bank of Canada and the federal government agreed to target an inflation rate of two per cent in 1991 following a period of high annual inflation that surpassed 12 per cent in 1981.

The two per cent target serves as a midpoint between a range of one and three per cent.

The bank explained in 2020 that this “resulted in good overall economic performance” and an agreement on this target has been continually renewed since, including as recent as 2021 through to 2026.

“We target inflation because a low, stable and predictable rate of inflation is good for the economy,” the bank said.

“When people and businesses feel confident that they know what the rate of inflation will be, they can make long-range financial plans. That leads to an economy that functions better. Average economic growth is stronger, and employment is higher.”

WHY 2 PER CENT?

The bank says an annual inflation rate at two per cent tends to be “when the economy is running near its capacity — when demand for goods and services is roughly equal to what the economy supplies.”

As the interest rate increases, the cost to borrow money for things like mortgages tends to rise as well, reducing demand and bringing inflation down over time. The reverse also occurs as interest rates fall.

The bank says because it takes time for changes in interest rates to affect all parts of the economy, the rate is set based on where inflation is expected to be 18 to 24 months in the future.

In a speech to the Toronto Region Board of Trade in May, Bank of Canada governor Tiff Macklem said the “job is not done until we restore price stability,” or until annual inflation is around the two per cent target.

“Price stability is important because it is a key ingredient to a prosperous economy,” Macklem said. “Low and stable inflation strengthens the competitive forces in the economy and allows Canadians to plan and invest with confidence that their money will hold its value.”

In a 2011 document, the bank cited a few reasons for not targeting an inflation rate closer to zero, in part because it would affect the bank’s ability to stimulate the economy.

Likewise, the bank says with a target closer to four or five per cent, higher inflation tends to be “more uncertain and volatile.”