The Bank of Canada should do exactly what it was doing before the Fed’s hike: setting its overnight rate at the level required to hit its 2-per-cent inflation target.
After a prolonged wait, the U.S. Federal Reserve raised its target for the Fed funds rate by 25 basis points last week. Its statement also hinted at three possible increases in 2017. Many Canadians are now asking if the Bank of Canada should raise its overnight rate in response. The short answer is “No.” Following the Fed’s rate hike, the Bank of Canada should do exactly what it was doing before the Fed’s hike: setting its overnight rate at the level required to hit its 2-per-cent inflation target.
That might seem like a simplistic answer. The Fed’s move, and the hawkish commentary that accompanied it, did send long-term interest rates and the U.S. dollar higher. Lots of people reacted. Shouldn’t we react, too?
Starting with the exchange rate, the Canadian dollar is now lower relative to the U.S. dollar. In a sense, that can stimulate the Canadian economy: Canadian products are now more competitive at home and in the United States, which should improve Canada’s trade balance and output. On the other hand, higher prices for goods and services purchased from the United States reduce Canadian purchasing power, and will put at least some upward pressure – however temporary – on Canadian inflation.
What about the U.S. economy – such a critical driver of Canadian exports and investment? The market reaction suggests many people thought the Fed was revealing inside knowledge that the U.S. economy is in better shape than we had thought. If the outlook for Canada is correspondingly better, a policy rate increase by the Bank of Canada just got more likely. If the Fed had left its policy rate unchanged, on the other hand, the medium-term outlook for U.S. spending and growth would have been more robust. In that case, the Fed’s hike makes the outlook for Canada less robust, and the case for a rate hike by the Bank of Canada just got weaker.
The conundrums do not stop there. Higher long-term interest rates may hurt housing and business investment in plant and equipment, in the United States and in Canada. Yet in Canada, higher long-term rates combined with an unchanged overnight rate result in a steeper yield curve. That’s an incentive for banks, which borrow short and lend long, to extend more credit, and typically a harbinger of an accelerating economy.
Rather than going down these and other rabbit holes, Canadian observers of monetary policy should look at what has not changed. The Bank of Canada has a mandate that now goes back more than two decades: To achieve 2-per-cent annual increases in the consumer price index. While monetary policy faces tactical challenges – often acute in the period running up to and since the 2008-09 crisis and slump – the framework for hitting that target is clear. The Bank tries to set monetary conditions that will promote spending and output that, over a period of six to eight quarters, will get the Canadian economy producing at full capacity, with inflation stable at 2 per cent. If actual output seems likely to exceed Canada’s productive potential, the Bank needs to slow things down. If actual output seems to be below potential, as it has recently, the Bank needs to speed things up.
The Fed’s framework is fundamentally the same. It also has a six-to-eight quarter horizon for achieving its inflation target. The Fed funds rate hike confirmed what many commentators inside and outside the Fed had been saying for months: that the U.S. economy is running closer to capacity, and ultra-accommodative monetary policy is less necessary than it was. That is good news, but nothing dramatic. What matters for the Canadian economy, and for Canadian monetary policy, is how changing U.S. demand will affect our trade balance, business investment, and overall private sector confidence – all of which will become evident in the months ahead.
So for the Bank of Canada, nothing critical has changed. Its key task is to get Canada’s inflation rate back to the 2-per-cent target it has hit, with remarkable regularity, over the past two decades. That means focusing on Canadian monetary conditions, spending, output and prices. We shouldn’t ignore the Fed. But it is doing its thing. We are doing ours.
