C.D. Howe Institute’s Monetary Policy Council Urges Bank of Canada to Raise Overnight Rate to 1.25 Percent, With Increases to 2.00 in April 2011 and 2.50 Percent by October 2011

Toronto, October 14 — The C.D. Howe Institute’s Monetary Policy Council (MPC) today recommended that the Bank of Canada raise its target for the overnight interest rate (the very short-term money-market rate the Bank targets for monetary policy purposes) to 1.25 percent at its next announcement on October 19, 2010. The Council recommended raising the target rate to 1.50 percent at the following announcement on December 7, 2010, followed by increases that would take it to 2.00 percent in April 2011 and 2.50 percent in October 2011.

The MPC is a panel sponsored by the C.D. Howe Institute to provide an independent assessment of the monetary stance most appropriate for the Bank of Canada as it seeks to achieve its 2 percent inflation target. William Robson, the Institute’s President and CEO, chairs the Council.

The MPC’s formal recommendations for each announcement date are its median votes. On this occasion, the medians were the product of two different tendencies among Council members. Five of the nine members attending the meeting recommended a target of 1.25 percent next week, while four recommended that the Bank hold the overnight rate at 1.00.

Those on the side of an increase next week tended to emphasize that the Bank should continue reducing its monetary stimulus to the economy, with a view to achieving a level of the overnight rate consistent with steady growth at 2 percent inflation once the disinflationary output gap in Canada has closed around the beginning of 2012. Members in this camp urged an overnight rate target in a range from 2.50 to 3.25 by October 2011.

Those favouring no change next week tended to emphasize recent signs that economic growth in Canada and abroad is weak, that Canadian inflation remains below target, and that inflation expectations remain subdued. While one member in this camp urged an overnight rate of 2.50 in October 2011, the others urged a rate of 2.00.

The state of demand for Canadian output relative to the Canadian economy’s productive capacity was, as has often been the case in recent MPC meetings, a major point of discussion. Aside from mixed signals from recent indicators of spending, output, confidence and intentions, the group was unsure about the degree to which changes in demand for Canadian exports, particularly those arising from structural changes in the US economy, meant that Canadian productive capacity is lower – and therefore that the disinflationary output gap is smaller – than conventional measures would suggest.

A related point of discussion was the level of the overnight rate that would be “neutral” – that is, consistent with stable growth and inflation once the disinflationary output gap has closed. Several members suggested a rate around 3.5 percent – 1.5 percent in real terms plus 2 percent inflation – but others stressed the uncertainties around any estimate of a neutral level for the rate, and the possibility that structural factors are lowering the real neutral rate over time.

A third recurring theme in the MPC’s deliberations was the motivation and potential effects of US monetary policy. Several members stressed inflationary tendencies in the US Federal Reserve, and the possibility that increased actual or expected inflation in the United States might raise inflationary expectations generally and cause the Canadian dollar to appreciate rapidly against the US dollar. Others thought the intent and/or practical effects of US monetary policy would be less simulative and less conducive to inflation. The group generally agreed, however, that whatever differences in economic prospects and inflation between Canada and the United States might do to the bilateral exchange rate, the Bank of Canada should continue to let the Canadian dollar float freely, and keep the 2 percent inflation target as the unambiguous centerpiece of its policies.

The table shows the median votes and individual recommendations for the overnight rate at the October 19, 2010 setting and the December 7, 2010 setting, as well as the group’s views about the target in 6 and 12 months’ time.

The views and opinions expressed by the Council’s members are their own and do not necessarily reflect the views of the organizations with which they are affiliated, or those of the C.D. Howe Institute.

The MPC’s next vote will take place on December 2, 2010, prior to the Bank of Canada’s interest rate announcement on December 7, 2010.

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Contact: Kristine Gray — phone: 416-865-1904; e-mail: kgray@cdhowe.org.