Stephen Gordon is a professor of economics at Laval University in Quebec City and a fellow of the Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE). He also maintains the economics blog Worthwhile Canadian Initiative and can be followed on Twitter.
The CD Howe Institute’s Monetary Policy Council (MPC) has been recommending since January that the Bank of Canada raise interest rates; Tuesday’s announcement was the fifth time in a row in which this advice was not followed. It’s worth noting that support for an interest rate increase is strongest among the MPC members drawn from the academic community: four of the five economics professors on the MPC supported an increase, while only one of the four private-sector MPC members did so.
The case for raising interest rates is based on the Bank of Canada’s expectation -- which was repeated in the July Monetary Policy Report (MPR) -- that the output gap will close in mid-2012. When this happens, disinflationary pressures will ease, and the Bank will not need to maintain low interest rates to maintain inflation at its 2 per cent target. And since interest rate movements are believed to affect inflation rates with a lag of somewhere between one and two years, the concern is that keeping interest rates too low for too long may produce inflation rates above target within the next year or two.
Technical Box 2 on pages 28-29 of the July MPR explains why the ‘headwinds’ facing the Canadian economy justify waiting to raise rates. I must confess that I didn’t fully understand it on first or even second reading. Most problematic was the graph showing a scenario in which the output gap has disappeared, the interest rate is below its long-run level, and inflation was at target. When we usually draw that sort of graph, a zero output gap combined with low interest rates would produce inflation that was above target. Moreover, I couldn’t reconcile the headwinds story with the projected dissipation of the output gap in the medium term.
Nick Rowe -- who happens to be a member of the MPC -- did understand what the Bank was saying, and he explains it in this post on Worthwhile Canadian Initiative. The basic point is that the neutral rate is not a fixed constant: an interest rate that is inflationary in one context may be disinflationary in another.
Exchange rate movements are an important factor in the determination of the neutral rate. When the Canadian dollar depreciates, imports become more expensive, and since much of what we consume is either imported or makes use of imported inputs, these higher costs are passed on in the form of higher prices. If the depreciation is sustained over a period of time, the continuing increase in prices will increase inflation rates above what they would otherwise have been. The same process works in reverse: a sustained appreciation in the Canadian dollar will reduce inflation.
When the Canadian dollar is depreciating, the Bank of Canada will be obliged to keep interest rates at a generally higher level than it would during a currency appreciation. Recent experience bears this out: the depreciation in the period before 2002 was produced interest rates that were generally higher than they were during the appreciation that followed; see the accompanying graph.
The notion of a temporary reduction in the neutral rate is certainly a plausible one: the Canadian dollar is likely to continue to appreciate against the U.S. dollar, and world interest rates are likely to continue to be below their usual levels. If the Bank thinks that the neutral rate is, say, somewhere around 2 per cent and if there are eight interest rate decisions between now and when the output gap closes, then it may feel justified in taking its time before deciding to increase interest rates.
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