People pass the Bank of Canada while travelling along Wellington Street in Ottawa on Oct. 23, 2023.Sean Kilpatrick/The Canadian Press
Claude Lavoie was director-general of economic studies and policy analysis at the Department of Finance from 2008 to 2023. He has also represented Canada at OECD meetings.
The current monetary policy framework agreement between the government and the Bank of Canada, which lays out the mandate of the central bank, is set to expire at the end of 2026. Some important structural changes should be contemplated for the next agreement, given the continued importance of supply shocks in driving inflation.
Inflation fell from about 8 per cent in June, 2022, to about 3 per cent in June, 2023. On the surface, this might be a sign that the Bank of Canada’s campaign of raising interest rates has worked, that it has sufficiently weakened demand to quell rising prices.
But interest rates take a while to work through the economy. And as inflation was falling, real GDP grew at a pace close to its 2-per-cent potential growth rate. While that is positive, it’s not what weak demand looks like. The Bank of Canada’s rate hikes cannot therefore be the reason for this large decline in inflation.
Rather, the reason was external. As argued by Nobel Prize winner Joseph Stiglitz and many other economists, “supply-side factors” (supply chain disruptions, trade restrictions, energy supply constraints) were the main cause of the postpandemic increase in inflation and the unwinding of these shocks are behind most of its decline since 2022.
And now that enough time has passed since the rate hikes, we can feel its impact. Growth has been anemic since the summer of 2023, largely because of monetary policy actions. Such a problem will only get more prevalent as supply shocks are set to increase.
This questions the bank’s current governance. Supply shocks by nature put monetary authorities in a bind. A negative supply shock, like the supply chain disruptions during the pandemic, increases inflation and hurts growth. With price stability as its sole objective, the Bank of Canada’s strategy to fight this inflation is to raise interest rates, but this ends up further hurting growth.
When demand shocks prevail, no trade-off exists between inflation and growth, so the central bank having inflation as its sole objective is not problematic since stabilizing inflation means also stabilizing output by what’s called “divine coincidence.” But since supply shocks create trade-offs between growth and inflation, having the bank considering only inflation is problematic given the social costs of lower growth and employment.
This is especially important for two reasons: Mark Carney (former governor of the bank) has noted that supply shocks – like climate change, aging, technological advances and geopolitical tensions – will continue to rock the world. And looking back, the supply-side factors appear to have been more important than thought. Constraints in energy supply explain much of the uptick in inflation in the 1980s, and globalization (for example, the entry of China in the global trading system), explain a big part of low inflation in the 2000s. Supply factors may also be behind a good share of the current residual inflation.
Other governments around the world have adapted by increasingly giving dual mandates to their central banks, directing them to equally weigh both inflation and growth. The Reserve Bank of New Zealand, the U.S. Federal Reserve and the Reserve Bank of Australia were all given a formal dual mandate. Canada may want to consider a dual mandate for its central bank as well.
The latest agreement between the Canadian government and the Bank of Canada started moving in that direction, stating the bank will use the flexibility within the inflation target band “to seek the maximum sustainable level of employment.” But it falls well short of a dual mandate, saying it will use this flexibility “only when consistent with price stability” and that “the primary objective is low inflation.”
Canada also needs to consider another move that other countries have done: When there are economic trade-offs to taming inflation, it is good to have a diversity of views around the decision table to ensure equal consideration of all effects. This is partly why most central banks make decisions by committees that include members of diverse backgrounds – academia, business and labour organizations – and not only central bankers. Most members of the monetary policy committees in Australia, New Zealand, Norway and Britain are external to their central banks. The Bank of Canada has a closed, consensual decision-making structure that is pretty unique among central banks and poses a greater risk of same-think.
The increasing prevalence of supply shocks may also question the appropriateness of the Bank of Canada’s current inflation-targeting regime. Studies show that, when supply shocks prevail, nominal GDP targeting yields better societal outcomes than inflation targeting. Some economists suggest it would also reduce the likelihood of recessions and improve financial stability.
All these questions should be part of the research agenda for the renewal of the monetary policy framework. And this research should not be conducted as usual. The Bank of Canada should not be the organization leading this agenda, to control for institutional bias. Monetary policy has significant social consequences beyond inflation and deserves the same scrutiny as other major policies.