Seeking a better measure of core inflation no easy task for Bank of Canada

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It looks like the Bank of Canada is signalling that it won't seriously consider raising its 2 per cent inflation target in next year's talks to renew its five-year inflation-targeting agreement with the federal government. But the push for a better measure of core inflation is full on.

In a speech in Halifax Tuesday entitled "Inflation Targeting – A Matter of Time," deputy governor Timothy Lane talked at some length about the central bank's attempts to use a variety of inflation measures to look through temporary idiosyncrasies to get at the broader underlying inflation trend. He noted that the bank would consider during the inflation-agreement renewal process whether its current measure of core inflation – known as CPIX, which excludes the eight historically most volatile components of the consumer price index – is the best means for tracking the inflation trend.

This is nothing new; the notion of a better measure for core inflation is one the Bank of Canada has kicked around quite a bit in the past couple of years. It was also a key part of a speech delivered by deputy governor Agathe Côté last November, which laid the groundwork for the central bank's priorities for next year's talks with the government on renewing the inflation-targeting mandate that has guided monetary policy since the early 1990s. (Indeed, Tuesday's speech may represent a passing of the bank's inflation baton to Mr. Lane from Ms. Côté, who oversaw the last renewal in 2011, but who will retire in January.)

But one of the biggest priorities Ms. Côté outlined nearly a year ago has become conspicuously absent from Mr. Lane's speech: Whether the bank should recommend raising its inflation target above 2 per cent, the well-entrenched inflation objective it has maintained through 20 years and five inflation-target renewals. The logic was that, in an environment of persistently low interest rates and a slow-growth economic trend that looked likely to keep a lid on the rate upside, a higher inflation target would promote moving rates further above zero, and thus give monetary policy makers valuable flexibility.

Mr. Lane's speech never even raises the possibility that the bank might want to increase the target from 2 per cent. Indeed, he stressed the importance of well-anchored expectations for inflation tied to "the credibility of our target," and concluded by saying, "We would like the public to take 2 per cent inflation for granted."

Even though the Bank of Canada published a research paper just a few weeks ago musing about the wisdom of a higher inflation target, the bank seems to have stopped talking about it in recent public communications on the topic of inflation targeting. A speech in Calgary last month by Bank of Canada Governor Stephen Poloz also touched on inflation-measuring issues in the upcoming target renewal, with nary a mention of the notion of raising the inflation target. Now, the absence of the target-raising question in Mr. Lane's speech – a speech that was specifically dedicated to the topic of inflation targeting – suggests the central bank is moving away from the idea, and will focus much more of its target-renewal efforts on revamping the way it measures core inflation.

Telling on that front is a new research paper published by the Bank of Canada in conjunction with Mr. Lane's speech, containing a detailed assessment of the bank's traditional core inflation measure as well as several alternative measures. The paper shows that, by and large, the CPIX is a pretty weak gauge of underlying inflation and correlates poorly with the output gap, the degree of spare capacity in the economy that is ultimately what the Bank of Canada is trying to track by focusing on inflation. While the paper doesn't quite conclude that the CPIX has outlived its usefulness, it certainly strongly suggests that other measures' time has come.

Yet there's one big sticking point. The best of those other measures are complicated, hard to both understand and explain. And that matters.

"A critical step in evaluating measures of core inflation is to assess whether they help to articulate the conduct of monetary policy in an easy and transparent way. This is … important given that core inflation measures are used in part to help communicate policy decisions," the study said.

And that's the dilemma the Bank of Canada faces. Pretty much everything in its research says that the CPIX is a poor measure of underlying inflation relative to the alternatives. But it's the one that the public can best understand, and for that reason may still be the most effective in firmly anchoring public inflation expectations – which is really the whole point of inflation targeting.

Still, the more the Bank of Canada pounds away at the alternatives, the more it looks disposed to moving past the CPIX as its operating guide (or, at least, its sole guide) for an inflation-targeted monetary policy. This is shaping up as the one key issue around which the renewal talks look destined to revolve.