The Bank of Canada is warning against inflation falling below the central bank’s two per cent target, which could lead to a deflationary cycle and pose a big risk to the economy.

“The idea of a period of no price gains — or even price declines — can sound tempting, particularly after three years of higher-than-normal price increases,” said Bank of Canada deputy governor Rhys Mendes, during remarks to the Greater Charlottetown Area Chamber of Commerce. “But there are trade-offs and risks involved in trying to push inflation below target, even temporarily.”

Mendes says in order for inflation to remain below two per cent, the central bank would have to keep the policy rate where it is now at 3.75 per cent, or even raise rates to reduce demand. This would impact mortgage holders, businesses and would eventually lead to layoffs and higher unemployment.

“In addition, there would be a risk that inflation expectations would drift lower,” Mendes said. “If this happened, it would limit the amount of stimulus that monetary policy can provide in response to a downturn and increase the risk of a severe recession.”

If consumers expect lower prices, they may put off purchases and wait for prices to go down. As demand weakens in response, businesses would lower their prices. This could lead to a “deflationary cycle,” according to Mendes, which can be extremely difficult to escape.

When inflation is stable at 2%, it fades into the background. This is what we are aiming for

Bank of Canada deputy governor Rhys Mendes

Mendes said keeping inflation at the two per cent target mitigates these risks. Inflation was able to come back down this year because Canadians’ long-term inflation expectations were well anchored, as the central bank had already proven over the last 30 years it was capable of keeping inflation stable at target.

“When inflation is stable at two per cent, it fades into the background,” he said. “This is what we are aiming for — and what we achieved for most of the 30 years before the pandemic.”

Mendes said the Bank of Canada is confident inflation will settle back to two per cent. He also said it is reasonable to expect further cuts to the central bank’s policy rate, but it will continue to take monetary decisions one at a time.

“We still have more information to come before our next decision in December, including third quarter gross domestic product data and the November employment numbers,” Mendes said.

“We’ll be looking closely at those indicators and reviewing any information we receive.”

• Email: jgowling@postmedia.com

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