The use of the term “headwinds” in the Bank of Canada’s Monetary Policy Report (MPR) released last week deserves more attention than it got. The headwinds metaphor made its first appearance in last July’s MPR, where it was used to explain another interest rate decision that had caught many by surprise.
During the first half of 2011, the Bank of Canada’s measure of the ‘output gap’ – the difference between actual and potential GDP – had been reduced considerably from the levels it had reached during the recession, and core inflation was at the 2 per cent target. Ordinarily, the appropriate policy stance for these circumstances would have been one of modest stimulus, but the policy rate was still at the very low level of 1 per cent.
The CD Howe Institute’s Monetary Policy Council had been recommending since January, 2011, that the Bank of Canada should begin increasing interest rates to levels closer to the ‘neutral rate’ that produces neither inflationary nor disinflationary pressures. The July decision was the fifth consecutive time that this advice was not taken, and the Bank explained its thinking in the July MPR.
The Bank chose the metaphor of ‘foreign headwinds’ that required Canadian monetary policy to work harder in order to maintain the same momentum. The European debt crisis was at a particularly critical juncture, and the U.S. economy was still deeply depressed. In other words, adverse conditions outside Canada had the effect of lowering the neutral rate of interest. A policy rate of 1 per cent was extreme stimulus for normal times, but those were not normal times. In the Bank’s view, a rate of one per cent was modest stimulus. (See also this from last July.)
The foreign headwinds have abated in the past few months. The European Central Bank has taken measures to reduce – although not eliminate – the risk of another major banking crisis, and the U.S. economy has shown signs that it is finally recovering from its recession. Without those headwinds, a policy rate of 1 per cent provides more stimulus than the Bank may be comfortable providing.
Even if conditions in Canada remain unchanged over the next few months, continued encouraging news from abroad could be reason enough for the Bank of Canada to increase interest rates.
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