April 25, 2023 – The Bank of Canada’s aggressive fight against well-above-target inflation offers central banks three key takeaways, according to a new report from the C.D. Howe Institute.
In “Slaying the Beast: The Bank of Canada's Ongoing Battle with Inflation,” authors Jeremy Kronick and Steve Ambler examine the evolution of the Canadian economy and the Bank’s monetary policy since 2020.
Building on their previous work, Kronick and Ambler analyze several different indicators of the Canadian central bank’s monetary policy stance over the post-COVID period to understand where and by how much the Bank of Canada fell behind the curve as inflation took off.
Kronick and Ambler use a series of different versions of the Taylor rule, which prescribes how the Bank’s policy rate should be set based on economic factors such as the gap between actual and potential output and the gap between actual inflation and the Bank’s target. The Taylor rules are complemented by a measure of money overhang. Estimating these rules gives a range for where the overnight rate might have been expected to fall during the COVID period to bring inflation back to target.
“Our analyses confirm that the Bank of Canada’s policy rate lagged behind its expected values during the fight against well-above-target inflation,” explain Kronick and Ambler. “To some extent, it still does today, however, most of the predicated values have peaked or are only slight above the current overnight rate.”
According to the authors, lessons for the Bank of Canada and other central banks include:
- the challenges in estimating the output gap in crisis periods exacerbated by huge supply chain bottlenecks, and the consequences for the appropriateness of forward guidance;
- the dangers of using year-over-year CPI when there have been large swings in prices, and the importance, then, of complementing the analysis with a month-over-month or other shorter duration measure; and finally
- the importance of money growth when it experiences large shocks, or changes, as a leading indicator of changes in inflation.
With the gap between the trend growth rate of broad money and inflation now closed, Kronick and Ambler write that the evidence suggests the Bank’s rate tightening cycle should be at its end. Additionally, headline inflation – which peaked in June 2022 – should continue to decelerate, aided by falling money growth, leading to a convergence between the policy rates recommended by the different rules analyzed and the Bank’s target overnight rate. Therefore, the Bank of Canada is right to pause its tightening cycle.
For more information contact: Jeremy M. Kronick, Director, Monetary and Financial Services Research, C.D. Howe Institute; Steve Ambler, Professor of Economics, Université du Québec à Montréal, and David Dodge Chair in Monetary Policy, C.D. Howe Institute; or Lauren Malyk, Communications Officer, C.D. Howe Institute, 416-865-1904 Ext. 0247, lmalyk@cdhowe.org
The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.