Today's economy

The Bank of Canada’s balancing act

By Kevin Press,

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It may be the most puzzling judgment call a Canadian policy maker has faced in decades. Stephen Poloz, the new governor of the Bank of Canada, will preside over a gradual uptick in the Bank’s overnight rate. That much is clear. What is less obvious is when he should start, and how quickly he should tick.

The Bank of Canada’s balancing act“That is a tough decision,” said Christopher Ragan, associate professor, macroeconomics and economic policy at McGill University in an interview with me last week. Ragan has a bit of advice for Poloz in an excellent paper called The Seductive Myth of Canada’s “Overvalued” Dollar. “He’s got to think about domestic inflationary forces. And he also has to think about financial stability concerns. Sometimes these line up in the same direction and demand the same policy response. Sometimes they don’t.”

In other words, economic stimulus has the potential to drive up inflation.

Ragan said Poloz faces a unique set of challenges because interest rates have been so low for so long. “Those are new problems that central banks haven’t been thinking about except in the last few years,” he told me. “You’ve got to balance those off with the standard run-of-the-mill monetary policy issues. He’s got a balancing act which I think is not easy.”

The key, Ragan writes in his report, is to focus on inflation as the driver of monetary policy. Those who argue that interest rate decisions ought to consider the value of the Canadian dollar versus its U.S. counterpart (some claim incorrectly that the loonie is overvalued) or that rates should remain low for the benefit of Canada’s export sector have it wrong.

“There are some people who think that because he came from Export Development Canada, he will be more open to this kind of argument,” said Ragan. “I believe that’s false. His job as governor is to do what the Bank of Canada is supposed to do, which is to keep inflation close to 2%.”

Why is inflation so important? “You’ve got to stay on top of it,” Ragan said. “The goal here is to keep inflation low and stable. High inflation is costly for the economy and it is invariably volatile.”

On that point, Ragan believes we can be optimistic. Despite worries that the stimulus measures taken in response to the financial crisis will drive inflation down the road, Ragan said the Bank of Canada’s strong track record counts for a lot. “The Bank has been running monetary policy with a 2% inflation target for almost 20 years,” he said. “Average inflation over the last 20 years has been just an epsilon away from 2%. So the Bank has achieved that credibility.” Ragan is right. The average annual inflation rate in Canada between 1993 and 2012 is 2.02%.

Where does he expect inflation to be over the short- to mid-term? “I think it’s going to be close to 2%,” Ragan told me. “Expectations are close to 2%, the central bank is targeting 2%, people believe the central bank can achieve its target and they have achieved that target.”

If he’s right, and inflation remains close to 2% despite all of the stimulus pumped into the Canadian economy, we can feel a whole lot more confident about the next few years.

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