MNI INTERVIEW: BOC Has Historical Bias Toward Easy Policy

The Bank of Canada has tended to react more forcefully when inflation falls below target than when it overshoots, authors of an academic paper digging into central bank staff forecasts told MNI, with one adding that their results would be consistent with relatively modest tightening in response to the current surge in prices.

Once inflation becomes low and stable, the BOC shifts its emphasis from inflation to the state of the economy, according to the paper examining policymaker actions from 1991, when Canada adopted inflation targeting, until the oil slump of 2015. Since 1995, when targeting was well established, the "BoC responds to the output gap and real interest rate, and also exhibits substantial inertia in the policy-making process," the research by Christos Shiamptanis and Ke Pang of Wilfrid Laurier University showed.

“The empirical evidence is telling us that they seem to be responding mainly on inflation undershooting, so inflation being below the target, and we don't find evidence for them to be responding on inflation above the target, especially in the period towards the end of our sample,” Shiamptanis said in a joint interview with his co-author.

The study, which became possible a few years ago when the Bank began publishing internal staff forecasts with a five-year delay, looked at whether rate changes followed `Taylor rules' responding to factors like inflation and economic slack.

SLOW PATH OF HIKES

Like other major central banks, the BOC says it has a symmetrical response to deviations from its 2% target, though investors globally have wondered if policymakers see these targets as more of a ceiling.

In January, Governor Tiff Macklem caused surprise when he held a record low 0.25% lending rate despite inflation at the highest since targeting began.

Macklem has said interest rates will now be on a rising path and markets see a move at the next meeting on March 2. But Pang said January’s decision to hold makes sense in the context of the Bank’s focus on more persistent and longer-term inflation expectations. Her current paper points to the prospect of modest tightening from here, she suggested.

“The Bank believes those inflation deviations are not going to be long lasting,” she said. The BOC's January economic forecast shows inflation returns close to 2% in late 2023, within its normal two-year horizon for getting prices back on track.

QE ADDS ANOTHER WRINKLE

“Inflation is not the only thing they're looking at," Pang added, citing concerns the economy may stumble again during the pandemic and that higher rates could destabilize markets or heavily indebted consumers.

Direct comparisons between the paper and now are difficult because the Bank has deployed QE in this downturn, something it didn't use in 2008 or at any other time covered by the study, the authors said. The Bank last year also renewed its inflation-targeting agreement with the government, adding new language about seeking full employment when possible.

Canada's reaction function is stable when a new Governor takes office, Pang said, noting that decisions are made by consensus within the rate-setting group.

The Bank of Canada declined to comment on the arguments by Shiamptanis and Pang, who coached students to victory at the 2019 Bank of Canada “Governor’s challenge,” where teams simulate the role of advisor to the Bank’s Governing Council. Canada has been more successful at keeping inflation near 2% than the Fed, ECB or BOJ even through the "Great Moderation" where global inflation was stubbornly weak.