October 29, 2024 – For the first time, Canadian policymakers have access to a real neutral rate yield curve, introduced in a new C.D. Howe Institute report that refines the understanding of monetary policy’s impact on the economy.
In “A New Monetary Policy Tool: The Real Neutral Rate Yield Curve for Canada,” Jeremy Kronick, Hashmat U. Khan, and Matt Soosalu distinguish between short-term and long-term real neutral interest rates, creating a full yield curve that reveals how tight or loose monetary policy has been over the past 30 years.
“The real neutral rate yield curve goes beyond the standard approach of analyzing a single neutral rate by examining multiple rates across different maturities,” says the report’s authors. “This approach provides comprehensive insights into both short-term and long-term monetary policy stances, critical with the Bank of Canada now engaging in both conventional and unconventional monetary policy.”
This tool is particularly relevant as the Bank of Canada continues its rate cutting after a severe tightening cycle to fight well-above-target inflation. “By comparing actual interest rates to these neutral rates across short- and long-term horizons, we can better understand how the Bank of Canada’s policy stance has shaped, and is shaping, economic conditions,” says Kronick.
The neutral rate is the interest rate at which the economy is operating at full potential without generating inflationary or deflationary pressures. The real neutral rate, which adjusts for inflation, provides a clearer picture of whether current monetary policies are aligned with or deviating from this balance.
The report highlights that real neutral rates in Canada have steadily declined over the past three decades, driven primarily by structural factors such as an aging population, globalization, and lagging productivity. Cyclical factors and policy interventions also play a role, particularly with respect to short-term neutral rates. The most recent data suggests that monetary policy remains tight at the short end of the curve, while the long end suggests it is loose, reflecting a more complex policy environment rather than a straightforward path for rate adjustments.
The full report presents a new approach to understanding Canada’s neutral interest rates, which is an essential resource for policymakers navigating an increasingly complex economic landscape.
“This paper provides central bankers and fiscal authorities with a more comprehensive view of how economic changes affect monetary policy decisions and vice versa,” Khan says. “It emphasizes the importance of considering both short-term economic conditions and long-term structural factors when assessing the stance of monetary policy.”
The real neutral rate yield curve will be available and updated every quarter as part of the C.D. Howe Institute’s Toolkit of Economic Indicators.
Jeremy Kronick, Vice-President, Economic Analysis and Strategy, C.D. Howe Institute; Hashmat U. Khan, Associate Vice-President (Academic Programs and Strategic Initiatives), Full Professor, Carleton University; Matt Soosalu, Ph.D. Candidate, Carleton University; Percy Sherwood, Communications Officer, C.D. Howe Institute, 416-407-4798, psherwood@cdhowe.org.
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. Widely considered to be Canada’s most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.