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December 18, 2018

"We believe that the success of the two per cent target sets a high bar for change."

There are signs of strain in the Bank of Canada’s monetary-policy framework that has served Canadians so well over the past quarter-century, delivering low and stable inflation.

Apparently aware of the challenges ahead, the bank’s senior deputy governor, Carolyn Wilkins, went so far as to say in a recent speech that the bank will review all its policy options leading up to the next renewal (in 2021) of the inflation-control agreement between the federal government and the Bank of Canada. While some cracks are appearing, we would argue tweaks are all that is required.

The Bank of Canada has targeted inflation since 1991 and kept the target at two per cent since 1996. The inflation-targeting framework has delivered stable inflation that averaged almost exactly two per cent from 1996 until the arrival of the financial crisis and recession of 2008-09. Unfortunately, average inflation has been below target since then. Coupled with a sluggish recovery, this systematic below-target inflation suggests the framework is showing some signs of strain.

One of the major challenges for monetary policy today is that real interest rates are lower now than before the recession. The implication is that the nominal “neutral” rate of interest — compatible with the economy at full capacity and inflation at the 2 percent target — is also much lower. As a result, central banks like the Bank of Canada now have much less room to lower rates in response to negative economic shocks.

Low interest rates have also led to increased household indebtedness, which the bank has been monitoring closely since the financial crisis. The good news is that lower interest rates have allowed households to carry higher mortgages without much of an increase in their debt-servicing costs. However, a greater danger exists from a drop in housing prices if economic activity slumps, since Canadian households are much more leveraged than before, and falling housing prices could lead to a deleveraging cycle that negatively impacts consumption spending.

Also problematic is the impact of an aging population. Changing demographics here and abroad have no doubt contributed to the fall in world real interest rates, but they have also acted as a drag on monetary policy effectiveness. This helps to explain the systematic undershooting of inflation since the financial crisis in Canada and in other inflation-targeting economies. In turn, this suggests that the Bank of Canada will have to make more significant changes to the overnight-rate target to affect aggregate demand and inflation than it did in the past, which is of course more difficult in a low-interest rate environment.

This low-interest-rate, below-target-inflation environment is the driving force behind the consideration of alternative frameworks. And there is no shortage of options for the bank being discussed: higher inflation targets, extending the period with which we measure inflation, and a dual mandate of inflation and economic growth, among others. We believe, however, that the success of the two per cent target sets a high bar for change. In addition, the bank can deal with the foreseeable problem of interest rates being too low to go lower by turning to quantitative easing. This could be done with only minor adjustments to the bank’s implementation of monetary policy.

In order to stimulate the economy during severe recessions the bank has to generate real (after inflation) interest rates that are actually negative. When the nominal interest rate is stuck at its effective lower bound, the only way to achieve this is by increasing inflation expectations. In order to make quantitative easing effective, the bank needs to target a permanent increase in the money supply. Despite the bank reducing the attention it pays to money supply — even omitting monetary aggregates from its Monetary Policy Report— the amount of money circulating in the economy remains a valuable metric for measuring, and forecasting, inflation and economic stability.

We wrote in our newly published book, Navigating Turbulence: Canadian Monetary Policy since 2004, that wheels typically are not repaired unless they are broken, and therefore we thought it unlikely that the Bank of Canada would revise its monetary policy framework in any major way unless there is another significant crisis and/or recession. However, the senior deputy governor’s speech suggests we may have been wrong on this front. If a change in the framework is truly being considered, we hope the Bank of Canada will consider tweaks instead of an overhaul. Following the money is a good start.

Steve Ambler is the David Dodge Scholar in Monetary Policy at the C.D. Howe Institute, and professor of economics at the University of Quebec at Montreal. Jeremy Kronick is associate director of research at the C.D. Howe Institute.

Published in the Financial Post