Canada’s economy is running at near full tilt, unemployment is lower than it’s been in four decades and inflation is close to the Bank of Canada’s 2-per-cent target.
So why is the central bank not moving faster to raise interest rates to more normal levels?
Blame it on the Bank of Canada’s pursuit of an elusive and constantly moving economic target – potential output. Figuring out the economy’s capacity to grow using all available workers and capital − and how fast it’s growing − is central to the bank’s work. It is the magic formula that central bankers use to figure out when to stoke the economy with rate relief, cool it with rate hikes or do nothing at all.
In a speech Wednesday in Ottawa, deputy governor Lawrence Schembri acknowledged that potential output is “a somewhat abstract notion.” The best the bank can do is come up with “reasonably robust” estimates.
“The main challenge in measuring potential output is that it is hypothetical, so it is not directly observable,” he said at the city’s Rideau Club. “We can only estimate it.”
The Bank of Canada has raised its key interest three times since last June, to 1.25 per cent, with the most recent hike in January. Many economists anticipated further moves this year, but so far the bank has been on hold, in spite of generally solid economic data.
That’s partly because the central bank moved the yardsticks in its April Monetary Policy Report by significantly revising up the level and growth of the economy’s potential output. It raised it to 1.8 per cent this year from a previous estimate of 1.4 per cent, and to 1.8 per cent next year from 1.5 per cent.
“That means that, in the near term, we have a bit more room than we thought to support demand without sparking undue inflationary pressures,” Mr. Schembri explained.
Mr. Schembri added that the bank recognizes “the difficulties associated with measuring potential and the related uncertainty.” He insisted the bank takes a “deliberate and rigorous approach” to managing unknowns. That includes using multiple models to predict where it’s moving.
Among the problems facing the Bank of Canada – and most central banks in wealthy countries – is that economies are generally slowing down as their populations age. Potential output is now growing at roughly 1.8 per cent per year in Canada, down from 2.7 per cent in the three decades leading up to the 2008-09 financial crisis and recession.
Mr. Schembri said Canada is still digging itself out of the hole.
“With the economy now operating close to potential, solid demand growth is spawning business investment, firm entry and improved labour market conditions – all of which are helping repair that damage,” he said.