A consensus is building that the major central banks are about to embark on monetary tightening. The era of low interest rates maybe over. All central banks have a primary mandate to set policy so that inflation is stable at a 2% annual rate. Anything below that rate means that the economy is underperforming and policy should be relatively loose to promote growth; anything above 2% can be interpreted that the economy is running “too hot” and needs to be reigned by means of a more restrictive monetary policy. So, everything rests on how good are the central bankers as forecasting inflation. Let’s look at the record.

Ted Carmichael examines the track record for the Bank of Canada (BoC).^[1]  Figure 1 compares actual total inflation to the BoC projections made 1 year earlier. The BoC consistently overestimated inflation. For the period of 2010-2017Q1, the error was an average of 63 percentage points, a considerable miss given that the target rate is 2%. He concludes his analysis with a stinging criticism, stating that “the BoC’s inflation projections since 2010 have shed virtually no light on where inflation was heading….it {the methodology used} is a poor guide to setting monetary policy.”

Should the BoC raise the bank rate next week, it can be considered that it has chsen to ignore the recent inflation record in favour of some other goal such as rate “normalization” or a  concern for the financial stability of the markets. It clearly cannot move on the basis of having reaching its inflation goals.

The FOMC has also come into sharp criticism regarding its inflation outlook. As Brad DeLong, internationally renowned economist, puts it “in terms of inflationary pressure, the Fed’s forecast seems to have significantly overstated the strength of the U.S. economy.”^[2]

What seems to be tripping up the central bankers is the relationship between falling unemployment and wage acceleration. The theory calls for wage pressure to increase as the unemployment rate falls. Japan has experienced what could be considered as “over full employment” as the unemployment rate fell to 3.5 % recently. Yet, wages have remained stagnant and inflation is non-existent. If Japan represents the future, Canada and the United States may continue to enjoy falling unemployment rates without any impact on the inflation rate. This will throw a monkey wrench into the inflation forecast techniques employed by the two central banks. More importantly, one wonders whether the 2% target is a realistic goal to aspire in setting monetary policy.