Canada’s two percent inflation target and policy framework has served the economy well, most importantly in anchoring inflation expectations.
June 24, 2015 – The Bank of Canada should focus monetary policy on inflation, not systemic risk, according to a new report released today by the C.D. Howe Institute. In “Securing Monetary and Financial Stability: Why Canada Needs a Macroprudential Policy Framework,” authors Paul Jenkins and David Longworth address the importance for the conduct of Canadian monetary policy of having a separate coherent framework for macroprudential policy – designed to prevent the build-up of systemic, or system-wide, financial risks.
“Two key lessons of the global financial crisis of 2008–09, were that regulators and supervisors paid insufficient attention to the buildup of systemic risks in the financial sector, and that price stability does not guarantee financial stability,” say the authors. “In turn, these two lessons underlie the arguments for macroprudential policy to deal with these risks and promote financial stability,” they add.
The report explains how the importance of this issue can be seen in two ways. First, it relates to the interactions between monetary and macroprudential policy tools in light of concerns about rising levels of household debt. At various times, there will be situations when only one policy tool is needed, when both policies need to be used in the same direction, or when the two policies need to work in opposite directions.
Secondly, this relates to the Bank of Canada’s current risk management approach to monetary policy. In the absence of a government framework for the active use of macroprudential tools, this approach implies that monetary policy becomes a more important line of defence against systemic risks than it needs to be, with the risk of sub-optimal monetary policy outcomes.
The findings presented by Jenkins and Longworth are threefold:
Canada’s two percent inflation target and policy framework has served the economy well, most importantly in anchoring inflation expectations;
over the past two years, Canadian monetary policy would have been better placed to combat low inflation and excess capacity had macroprudential policies been openly geared to reducing the systemic risks associated with rising household indebtedness and housing prices; and
drawing on best practices, the government needs to elevate macroprudential policies by establishing clear objectives, tools and lines of responsibility and accountability.
The authors argue that there would be significant advantages to the Canadian economy overall, and to the Bank of Canada as the monetary authority, in having a well-formulated macroprudential policy that specifies the active macroprudential policy tools to use to limit systemic risks, and thereby to promote financial stability. “The payoff for Canadians cannot be overstated: greater assurance of financial stability as a result of the direct assignment of responsibilities for active macroprudential policy, and of monetary stability as a result of the Bank of Canada’s continued primary focus on inflation and output stabilization,” they conclude.
Click here for the full report.
The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. It is Canada’s trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review. It is considered by many to be Canada’s most influential think tank.
For more information contact: Paul Jenkins, Senior Fellow, C.D. Howe Institute, and former Senior Deputy Governor at the Bank of Canada; David Longworth, Research Fellow, C.D. Howe Institute, and former Deputy Governor of the Bank of Canada; or Finn Poschmann, VP Policy Analysis, C.D. Howe Institute; 416-865-1904, or email:amcbrien@cdhowe.org.