Bank of Canada Governor Tiff Macklem waits to appear before the House of Commons Finance Committee, Nov. 23 in Ottawa.Adrian Wyld/The Canadian Press
Steve Ambler is a professor of economics at Université du Québec à Montréal and David Dodge Chair in Monetary Policy at the C.D. Howe Institute. Jeremy Kronick is director of monetary and financial services research at the C.D. Howe Institute.
Last week, the Bank of Canada raised its policy interest rate by 50 basis points, to 4.25 per cent, in line with market expectations of either a 25- or 50-basis-point increase. No surprises there.
The real news was the change in the tone brought by the announcement. Of late, the bank has repeatedly warned Canadians that more rate hikes were coming. Now, further tightening will “depend on the data.”
We think this is a welcome development – and not just because it means the potential end of the tightening cycle, but because the bank gives itself more wiggle room in a very uncertain environment.
More definite statements can be problematic. Back in the second half of 2020, with the overnight rate at its lower bound, the bank told Canadian households and businesses that interest rates would be kept low for a long time.
This is what economists call forward guidance, where the central bank attempts to provide predictability on the path ahead, so people and businesses can proceed confidently with major planned purchases and investments.
That, unfortunately, contributed to runaway inflation and a too-hot economy the bank is now trying to cool – revealing the dangers of forward guidance we are seeing today.
People listened to the bank and borrowed and spent. Many Canadians who heeded the call to take out mortgages at rock-bottom interest rates face significantly higher interest rates today. Some haven’t felt the pinch yet because they have fixed-interest-rate or variable-rate/fixed-payment mortgages, but they are likely to face one soon.
The issue is that forward guidance binds the bank to a rigid plan – or, at least, there’s the perception of that. That is not a good thing when the environment changes wildly beyond expectations. People think the bank will continue on its predetermined path, and they make spending decisions that make things worse for both themselves and the economy.
It’s a good thing the bank did not fully stick to the path set by its prior forward guidance, even if it did, perhaps, stay on it longer than necessary.
Consider that in December, 2020, with headline inflation still well below target at 0.7 per cent, the bank announced that, “Governing council will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2-per-cent inflation target is sustainably achieved.”
This was a commitment that was conditional on one aspect of the data – the output gap, which is the difference between actual and potential output of the economy. If economic slack is measured by the bank’s two calculated output-gap indicators, it remains negative today (-2.1 and -0.4 per cent in the third quarter of 2022) – the slack is still not fully absorbed, despite an unemployment rate close to record lows.
If the bank had stuck to its promise of December, 2020, we would still have a policy rate at its effective lower bound. Indeed, that promise of December, 2020, might have been in part responsible for the bank being behind in its timing of interest-rate hikes. By the time it had started to raise its policy rate in March of this year, inflation had already soared to 6.7 per cent and was on its way to 8.1 per cent in June.
Similar dangers lie on the tightening side – when interest rates are going up – where too much forward guidance leads to a much deeper dampening of economic activity than is necessary. With the bank’s indications last week that the tightening cycle should come to an end, the move to more data dependence is even more appropriate.
It is true that headline inflation (CPI) is still looking stubbornly high, at 6.9 per cent in October. On the other hand, as we have previously pointed out, this metric has a lot of built-in persistence that does not readily reflect the current situation, which is actually starting to look better.
For example, the three-month annualized rates of CPI Trim – so-called because it trims out the parts of the price change in volatile components – has already fallen to 3.4 per cent from 7.8 per cent in May. CPI Median inflation – another core measure – has fallen to 3.3 per cent from 7.4 per cent in May.
The bank will be getting lots of new information before its next decision in January, including headline inflation for November and December, labour force survey data for December and industry GDP data for October. If inflation continues to fall, and if economic conditions prove weaker than forecast, the bank will want to end its tightening cycle so that its policies don’t throw the economy into recession.
The bank’s announcing last week that its interest-rate policy will be more data dependent is a welcome change. We would suggest a further tweak to the bank’s communication strategy. It should reduce its focus on headline inflation. While headline inflation is the mandated target of the bank, more telling measures of inflation as discussed above give a better take on where inflation is headed. Focusing on more appropriate metrics in its communications will help condition markets to expect and accept a pause in the tightening cycle – no forward guidance needed.