Senior deputy governor Tiff Macklem said Friday that the central bank is concerned about Canada's inflation rate either going above or falling below two per cent, which has been the average for the past 20 years.
"We need to do our best to determine why inflation is below target, but no matter how hard we try, there will be uncertainty about our diagnosis," Macklem said in his last speech as the central bank's senior deputy governor.
When inflation is above two per cent, it erodes purchasing power and creates uncertainty and when it's below two per cent it depresses demand as consumers expected prices to go down further, he said.
"But sustained negative inflation — or deflation — is even more pernicious," he said.
He recalled the high and volatile inflation in the 1970s and 1980s and said the best way to mitigate fluctuations in production, trade, prices and employment is to keep inflation low, stable and predictable.
Macklem said the economic puzzle of low inflation appears to reflect a combination of bad and good disinflation, which refers to declining inflation.
He said bad disinflation stems from persistent excess supply in the economy, while good disinflation results from more competition in the retail sector, with newer and bigger retailers, cross-border shopping and online purchasing.
"It is difficult to predict how long increased competition will weigh on inflation, but in our base case projection we assume that it will continue to drive prices lower for about another year," he told about 100 students at Montreal's Concordia University.
He also said increased competition will have a permanent effect on the level of prices but only a "transitory" impact on inflation.
A number of studies have indicated there's a global dimension to inflation, which is currently low and falling across a wide range of advanced economies, Macklem said. Global total inflation is strongly correlated with global energy and food price, he said.
"This suggests that much of the recent decline in global total inflation can be explained by the recent fall in world energy and food prices."
Macklem said in theory, monetary policy should work to counter bad disinflation stemming from weak demand.
But in practice, he says it's more like an exercise in risk management, as there's still considerable uncertainty surrounding the bank's measurements and projections.
"Our work at the Bank of Canada is both to sharpen the analysis as much as we can and, at the same time, to take account of the risks and uncertainties as we determine the appropriate course for monetary policy to achieve our inflation target."
Some uncertainty about the bank's judgments include how long increased competition will depress inflation, he said.
"We are doing our best to identify the main drivers of disinflation and are continuously assessing their impact on the economy and their persistence."
While there are no signs of a rebalancing towards exports and business investment in Canada, the strengthening of the global economy and the recent depreciation of the loonie should foster a broadening of the composition of growth in Canada, Macklem said.