The Bank of Canada might let inflation stray from its renewed 2 percent target under exceptional circumstances, for example if an asset bubble threatens the economy or if financial markets are too unstable to cope with higher rates.
Explaining a decision to renew its inflation target for five years, the Bank of Canada said on Wednesday that it would occasionally accept short-term deviations from its inflation target in order to combat financial instability.
The global economic crisis delivered a powerful reminder that price stability and financial stability are inextricably linked, and that pursuing the first without due regard for the second risks achieving neither, it said in a policy paper that highlighted the need for flexibility.
While this flexibility might involve sacrificing some inflation performance over the usual policy horizon, it would lead to greater financial, economic and, ultimately, price stability over a somewhat longer horizon.
Normally, the bank sets rates in order to bring inflation to target over a period of six to eight quarters. But that horizon can be longer, depending on the circumstances.
The bank said it had so far not had to use flexible timelines for inflation to lean preemptively against financial imbalances. But it noted other circumstances, such as the global recession and its aftermath, which could also require such flexibility.
The Bank of Canada says flexibility has been part of its framework for decades, but Governor Mark Carney has emphasized it more since the financial crisis.
Renewing an inflation-targeting policy that has been in place for two decades, the government and the Bank of Canada said on Tuesday the bank would target an annual inflation rate of 2 percent, within a control range of 1 to 3 percent, matching the policy of the last 15 years.
Tuesday's statement did not mention flexibility in the timeline for returning inflation to target or of any role for monetary policy in ensuring financial stability.
The financial crisis has prompted central bankers to look more closely at what role monetary policy can play, in extreme circumstances, in leaning against asset bubbles.
But the Bank of Canada made clear that its role was limited, echoing U.S. Federal Reserve Chairman Ben Bernanke in saying that interest rates are a blunt tool that should only be used to lean against credit buildup when supervision and regulation are not enough.
The bank said it would only use monetary policy to push against asset prices when they threatened the health of the overall economy, not just one sector of it.
Over the last five years, the bank had looked closely at two possible changes to its inflation targeting policy: lowering the target or switching to price-level targeting, a different method for keeping prices low and stable.
During the crisis it tacked on a third option: whether monetary policy should also play a role in supporting financial stability. The bank said it had judged there were too many pitfalls with the first two options.