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The Governor of the Bank of Canada said the bank’s new monetary policy framework could lead it to be more “patient” in raising interest rates as it looks to support full employment, although this would depend on having inflation under control and interest rates closer to normal levels.

Tiff Macklem used a virtual speech to the Empire Club of Canada on Wednesday to outline the thinking behind the bank’s new mandate. On Monday, the federal government and the bank announced a new inflation-targeting framework, which will guide Canadian monetary policy for the next five years.

The new framework reiterates the bank’s focus on hitting 2-per-cent inflation within a 1-per-cent to 3-per-cent band, but emphasizes the use of monetary policy to support “maximum sustainable employment” when “conditions warrant.” This is a significant shift in the language of the framework, although it stops short of a “dual mandate,” like the U.S. Federal Reserve has, targeting both price stability and full employment.

Mr. Macklem said that the bank may use the flexibility of its 1-per-cent to 3-per-cent inflation control range “to actively seek the maximum level of sustainable employment.” That means allowing inflation to run slightly above 2 per cent to support a strong labour market. But he said that inflation control remains the bank’s paramount goal, and that the bank would only “seek” or “probe” for full employment under certain circumstances.

“When might conditions warrant? When inflation is close to target, interest rates are at more normal levels, and we’re not sure if we’ve really reached maximum sustainable employment. That is not the current situation, of course, since inflation is now already considerably above our target and our policy interest rate is very low,” Mr. Macklem said, according to the prepared text of his speech.

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Statistics Canada reported Wednesday that the annual rate of inflation remained at 4.7 per cent in November. Persistently high inflation has forced the bank to start tightening its policy sooner than expected, winding down its government bond-buying program, also known as quantitative easing, in October and signalling that rate hikes are coming in the middle quarters of next year.

In explaining the new approach to maximum employment, Mr. Macklem noted the bank’s experience assessing unemployment and inflation shortly before the pandemic. At that time, unemployment was at 40-year lows, but inflation was not taking off in the way economic models would have predicted.

Traditional central bank models rely on a relationship between unemployment and inflation that economists call the Phillips curve: Low unemployment means high inflation, high unemployment means low inflation. In the past, when central bankers saw unemployment reaching low levels, they would raise rates to pre-empt rising inflation.

This relationship, however, has grown weaker in recent decades, for a range of reasons tied to globalization, weaker labour unions and technological change.

“Based on past economic cycles, we would have expected inflationary pressure to begin to increase,” Mr. Macklem said of the bank’s experience in 2019. “But inflation was not rising above the target. By being patient [and not raising rates], the Bank learned that the level of employment that is consistent with price stability was higher than most previous estimates.”

Mr. Macklem also used the speech to outline how the bank intends to deal with a problem faced by central banks around the world: the structurally low neutral rate of interest – that is, the interest rate level in the economy that neither constrains nor stimulates inflation.

The neutral interest rate has declined precipitously over the past few decades, driven by changing demographics, technology and patterns of savings and investment. The result is that central banks are more likely to find themselves in circumstances where they can’t cut their policy rate to stimulate the economy through a recession, because the rate is already close to zero.

This “effective lower bound” (ELB) problem has led central banks to rely more on extraordinary policy tools such as forward guidance (promising to hold rates low for an extended period of time) and quantitative easing (buying huge amounts of government bonds to hold down longer-term interest rates). The Bank of Canada used both tools during the pandemic, after its policy rate hit the effective lower bound of 0.25 per cent within the opening weeks of the pandemic.

“With low global interest rates, the Bank is likely to lower its policy rate to the ELB more often in response to shocks. That means we may need to use forward guidance and our balance sheet more often than has been required in the past,” Mr. Macklem said.

The use of forward guidance means that there will be circumstances where “inflation will likely go a little above the target after we exit from the ELB before it comes back to the target over the medium term,” he said.

This dynamic could play out in the coming years, as the central bank winds down forward guidance launched in response to the pandemic. While the bank expects the rate of inflation to decline to close to 2 per cent by late next year, by promising to hold rates low until slack in the economy has been “absorbed,” the bank is forecasting inflation will remain above 2 per cent into 2023.

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