Before the financial crisis came along, the main question of Canadian monetary policy was whether to revise the Bank of Canada's 2% inflation target. Should the Bank target a lower inflation rate, like 1%, or even 0% inflation? Or should the Bank switch to a target path for the price level?
Dealing with the financial crisis is urgent. The news changes daily. Policy changes almost as quickly. Blogs seem to be the only medium in which policy responses can be debated. All the other media (books, academic journals, even working papers) are just too damned slow.
Revising the Bank of Canada's inflation target is much less urgent; the decision won't be made until 2011. I'm not sure whether it is more or less important in than dealing with the financial crisis, but I confess that it's hard to get up the same level of excitement or mental focus right now.
The Bank of Canada has a website intended to act as a focus for research and discussion of the inflation target. It contains links to relevant research, a wiki, and a discussion forum. These are not restricted to Bank of Canada employees. Anyone can read them, but you have to apply to be allowed to edit the wiki or post in the forum. (I've just applied; I wonder if they will let me register?) I think it's a very good idea, and I very much hope it succeeds as a focus for information and debate, for economists both inside and outside the Bank. But so far it has not been very active. Maybe nobody knows about it?
I am going to make one small contribution to the debate right now. I predict that Tuesday morning the Bank of Canada will cut its overnight rate to below 2%. This is actually a fairly safe prediction; everybody else is saying the same thing. But if it does cut the overnight rate below 2%, this will be the death of any proposal to target 0% inflation.
Imagine an alternative universe in which the Bank of Canada had been targeting 0% inflation rather than 2% inflation over the last 15 years. Actual inflation would have varied around 0%, in much the same way that it has actually varied around 2%. And expected inflation would also have varied around 0%, in much the same way that it has actually varied around 2%. To keep real economic activity growing at the same sort of rate under a 0% inflation target as under the 2% inflation target, real interest rates would have needed to be the same under the 0% target as under the 2% target. But since the real interest rate is the nominal rate minus expected inflation, this means that nominal interest rates would need to have been two percentage points lower in the alternative universe with the 0% target than they have been under the 2% target.
So if the Bank of Canada cuts the nominal overnight rate to (say) 1.75% on Tuesday, that means in the alternative universe, with a 0% inflation target, the Bank would have cut the overnight rate to minus 0.25%. Which is a contradiction, because nominal interest rates can't go negative. In the alternative universe, the Bank would be in an absolute liquidity trap by Tuesday. That's a nasty place to be.
Cutting the inflation target from 2% to 0% would have given the Bank of Canada 2% less sea-way before hitting the rocks. It would have 2% less ammunition in its magazine to shoot the bear. Pick your own metaphor, as long as it implies danger.
Of course, even when the nominal overnight rate is at 0%, the Bank of Canada still has other weapons. But those weapons are untried, and the Bank is uncertain how to use them, and how powerful they will be. The Bank has 15 years' experience of adjusting the overnight rate to keep inflation on target, and practice makes…at least improvement, if not perfect. It has no experience with using quantitative easing or money-financed fiscal policy as means to keep inflation on target. It will make much bigger mistakes, because these tools of monetary policy are qualitatively different. The cost of those mistakes are unknown, but would likely be much worse than the small benefits of bringing inflation down from 2% to 0%.
By Tuesday morning, any proposal to target 0% inflation will be dead.
Worthwhile Canadian Initiative 
I don’t know whether it has been released yet, but Michael Parkin has recently completed a CDHowe commentary recommending that the Bank pursue a zero percent inflation rate (assuming inflation is measured correctly).
John: There’s an early version of Michael’s paper available here economics.uwo.ca/workshop/politicaleconomy/parkin_nov13.pdf
But he’s not arguing for a 0% inflation target; he’s arguing for a 0% (or 0.6%, to handle CPI bias) price level path target. It’s a subtle difference, and maybe I will post on that difference soon.
My argument only applies to 0% inflation targeting. Michael could argue, very reasonably, that the pattern of expected inflation would be very different (not just 2% lower at all times) in an alternative universe where the Bank had been targeting a constant price level. If there were deflation, for example, people would expect subsequent inflation, as the Bank of Canada corrected that past mistake and brought the price level back up to target. That increase in expected inflation, during a deflationary episode, would mean that real interest rates would be lower, so the Bank wouldn’t need to cut the nominal rate as much to prevent deflation. It’s an interesting and important point.
A very big problem with zero inflation, rather than a moderate level of say 3-4%, is that real prices and wages are far more sticky at zero inflation. Workers are much less resistant to taking a real paycut if it doesn’t involve a nominal paycut. In other words, the empirical evidence shows overwhelmingly that most workers are far more resistant to a 3% paycut when inflation is 0, than they are to a pay freeze when inflation is 3%, even though they are basically the same thing.
With housing it’s huge. People are absolutely loathe to take a significant percentage loss on a home, for the obvious reason that it’s a huge amount of money. They will not cut their price for months or years, without selling, thus greatly slowing the market’s working out of a glut which is contributing to a recession. But, people are far more willing to not take a nominal loss by not cutting their nominal price, but take a huge real loss by significant inflation cutting their real price.
In other words, real prices are a lot less sticky when there’s significant inflation, and this benefit far outwieghs what’s been shown to be relatively small costs of inflation in the moderate range. Prices and wages adjust a lot faster to efficient levels to end gluts and get and keep people working and goods moving.
Here’s a Canadian example: Nobel Prize winning economist Paul Krugman notes this in his 1996 Economist article, “Fast Growth and Stable Prices: Just Say No”:
It can also take a while for a person looking for work to understand and/or admit that the equilibrium wage in his field has dropped, and he has to accept less. It’s not just bad luck that he’s getting lower offers than were common last year, and instead the market has, in fact, changed. It can take a while for an individual to discover this, with all of the complication and random factors in the labor market. This is known as the Misperceptions theory.