Last Wednesday’s interest rate announcement and Monetary Policy Report (MPR) from the Bank of Canada were the first under new governor Tiff Macklem. They provide welcome clarity on the bank’s thinking about the economic impact of the coronavirus pandemic and how monetary policy should respond
Back in March, the bank cut its traditional policy instrument, the target overnight interest rate, to 25 basis points, alongside heavy interventions in financial markets to provide liquidity. The high degree of uncertainty associated with the virus and the ensuing economic lockdown led the bank to be vague in its accompanying commentary, including the key question of how it intended to hit its two per cent inflation target. The April MPR did not include the bank’s traditional economic forecast, presenting instead two starkly different scenarios, with no indication of which the bank thought more likely.
This time the bank gave us much more.
First, it provided explicit forward guidance concerning its interest-rate target, committing to “hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the two per cent inflation target is sustainably achieved.”
Second, the MPR provided a central economic scenario through to the end of 2022. Recognizing that its assumptions concerning the pandemic itself are an educated guess, the bank laid out a scenario that assumes there will not be a second wave severe enough to throw the economy back into lockdowns, and that 2022 will see widespread availability of a vaccine or effective treatment. With that central scenario showing inflation at only 1.7 per cent at the end of 2022, the overnight rate will be at its effective lower bound for quite some time.
Third, the MPR provided forward guidance about quantitative easing (QE). It stated that the bank will purchase at least $5 billion per week of Government of Canada bonds until “the recovery is well underway.” Although at first QE was intended as a liquidity tool to ensure financial markets functioned properly, its focus now is to keep interest rates low across the yield curve and help stimulate the economy.
An additional helpful element in the MPR was an analysis of how changes in consumers’ spending patterns have affected the consumer price index (CPI). In co-operation with Statistics Canada, the bank is constructing an adjusted price index with weights that reflect more up-to-date purchasing patterns. The adjusted index shows less downward pressure on prices. With many goods and services being effectively unavailable (e.g., travel), declines in their prices are irrelevant to consumers. This new measure should make for a more accurate reading of the cost of living Canadians are actually facing, and that will allow monetary policy to react more appropriately. The bank’s inflation-control target is defined in terms of the CPI and efforts to keep the CPI more current are always helpful.
Finally, the MPR gave a clear picture of how the bank sees the shortfall between actual and potential output and the implications of this shortfall for inflation. With output down 15 per cent in the first quarter, and 60 per cent of that representing lost or idled capacity, the output gap that matters for inflation is likely six to seven per cent. This is valuable context for the MPR’s central economic scenario, in which the output gap does not close until 2022. Anyone who thinks the recovery will be faster, or slower, can make a more informed judgment about how long the bank will keep the overnight rate at 25 basis points.
We would like to see one more piece of information to complete the portrait of the bank’s pandemic strategy. Since the emergency cuts to the overnight rate, the deposit rate — the interest rate banks receive for holding positive settlement balances with the Bank of Canada — has been set equal to the rate banks get when lending to each other overnight. This reduces banks’ incentives both to lend to each other and to expand their loan portfolios to households and firms. The bank could be more explicit about whether this situation will continue and, if it does, how the bank intends to encourage the financial sector to meet an increased demand for borrowing in an environment of exceptionally low interest rates.
In uncertain times, clarity from public officials is valuable. The latest Monetary Policy Report provides not just a snapshot of where we are, but helpful guidance about where we may be headed.
Published in the Financial Post
Jeremy M. Kronick is associate director of research at the C.D. Howe Institute, where William Robson is CEO and Steve Ambler, professor of economics at the École des sciences de la gestion, Université du Québec à Montréal, is David Dodge chair in monetary policy.
