Against inflation risk, Bank of Canada must ruffle feathers and act early

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There’s a fine line between patiently standing your ground and becoming a deer in the headlights.

The Bank of Canada is now approaching that line. And on Wednesday, it dug its feet in a little deeper, rather than readying itself to rapidly spring to action if it becomes necessary.

History has shown it’s not impossible to shift out of this kind of policy inertia in a hurry, with the right motivation. But the central bank risks burning some credibility bridges by not getting on the balls of its feet sooner.

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The central bank had both opportunity and justification to use Wednesday’s interest rate announcement to take at least take a tiny step toward the launch of rate increases. Since nudging that launch a bit earlier in its previous rate decision in late October, a couple of the most important ingredients in that decision – rising inflation and a surging labour market – have added considerably to the case for raising rates sooner rather than later.

The bank didn’t do that. It held its key rate steady. In the critical sections of the statement, it left its wording unchanged from the October decision. Facing already elevated inflation, an economy that might already be at full employment, and rising wage pressures, the bank didn’t move the needle at all on its rate timing.

Indeed, the bank’s “forward guidance” – its explicit statement outlining the key criteria for starting to raise rates – hasn’t changed since it spelled out the criteria in July of 2020. The bank remains committed to leaving its key rate unchanged “until economic slack is absorbed so that the 2-per-cent inflation target is sustainably achieved.”

But when it set those rules, no one had envisioned inflation at nearly 5 per cent; the bank’s chief concern at the time was staving off dangerously low inflation. No one had anticipated a labour market straining at its limits long before gross domestic product had fully recovered.

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Conditions have changed. Waiting for the perfection of the forward guidance has become much more risky than the bank could have anticipated a year and a half ago.

Back in October, the bank signalled that the earliest it envisioned starting to raise rates would be April. (It gave itself a sizable two-quarter window, the second and third quarters of 2022.) Wednesday’s non-decision decision keeps that timing intact.

By convention, the bank has a strong preference to announce policy shifts on the four occasions each year its rate decision is accompanied by a quarterly Monetary Policy Report, which provides updates of its economic forecasts and a platform to explain itself in detail.

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The next rate announcement and MPR is in late January – at which point the bank would have a good opportunity to hint that the start of rate hikes could come toward the early part of its window. The next announcement and MPR date after that – April 13 – is the one many bank watchers have already circled as the likely liftoff date.

Whether an already pretty hot economy will wait another four months is, frankly, a risk – especially considering that it takes months for the effects of interest rate changes to work their way through the economy.

The central bank is still pretty confident that inflation will retreat, and it believes the Omicron variant of COVID-19 and the flooding in British Columbia will slow the economic recovery for a while. But if things don’t pan out, April could look a very long way off.

Still, the bank isn’t actually required to provide advance warning before making a move – and, indeed, it has a notable precedent for making a surprise about-face. Seven years ago, amid a severe oil market crash, the bank swung from a stand-pat December rate decision that contained not the slightest glimmer of future rate changes, to a quarter-percentage-point rate cut just seven weeks later.

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The message from then Bank of Canada governor Stephen Poloz was that the oil shock had rapidly changed Canada’s economic equation. He characterized the rate cut as taking out “insurance” against the serious downside risks the oil slump posed.

In the moment, the move stunned financial markets, and Mr. Poloz came under a lot of criticism for taking a rash and poorly signalled action. Even among observers who gave him the benefit of the doubt, the move looked, at very least, premature.

But in hindsight, the decision is credited for pre-empting what could have been a full-blown Canadian recession had the bank sat on its hands. It was, frankly, a very good thing that the bank acted early.

Nevertheless, it was a communications disaster. It took some serious damage control to clear up market confusion, and months or even years for Mr. Poloz to regain trust among a business community and public that felt misled.

The bank could be fast approaching the need for another similar insurance policy – this time against the risk that inflation may take on a life of its own. The lesson from 2015 is that acting early and decisively is ultimately more important than ruffling a few feathers. But if it wants the best outcome on both those fronts, it needs to loosen its attachment to its old script – and any old thinking tied up in it.

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