Questions of balance at the heart of Bank of Canada’s mandate renewal

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When Tiff Macklem became Bank of Canada Governor at the height of the first wave of COVID-19, the economy had just taken the steepest plunge in living memory and much of the country remained in lockdown. Policy makers eyed the landscape nervously, waiting to see if a wave of bankruptcies or permanent damage to the labour force would weigh down consumer price growth. The overarching fear was deflation.

Sixteen months on, the situation has reversed. Inflation has run above the central bank’s target range of 1 per cent to 3 per cent since April, hitting an 18-year high of 4.1 per cent in August. Around the world, a debate is raging about whether this spike in inflation is a temporary blip caused by gummed-up supply chains and wonky data, or a sign that unprecedented fiscal stimulus and wide-open monetary policy during the pandemic has caused inflation to become unmoored.

High inflation could be ‘a little more persistent’ than expected, BoC’s Macklem says

Against the backdrop of this inflation whiplash, Mr. Macklem and newly re-elected Finance Minister Chrystia Freeland face crucial decisions about the future of monetary policy. Every five years, the central bank renews its mandate with the federal government – a process that’s expected to wrap up in a few months. The choice at hand is whether to renew the existing flexible inflation targeting regime or move to a system that looks at other factors.

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Two leading alternatives are a dual mandate that would target full employment alongside inflation; and an average inflation targeting regime that would look to make up for inflation misses during the economic cycle, and aim for higher inflation coming out of recessions.

The recent run-up in inflation has complicated matters. Much of the Bank of Canada’s research for the mandate renewal was done before the pandemic, when the principal concern for central bankers was low inflation and sluggish growth.

Now, as the renewal process enters the home stretch, the question is how much weight to put on today’s inflation worries, and how much to focus on the longer-term shifts in the economy that preceded the pandemic and could persist long after the virus has been brought under control.

“It would be a pretty drastic move to change your mandate based on a few months of inflation pressure,” said Benjamin Reitzes, director of Canadian rates and macro strategist with BMO Capital Markets. “But it’s not a one-way street anymore. The worries are more two-sided.”

Inflation targeting has been the core of the bank’s monetary policy system since 1991. It lays out a path for consumer price increases, giving central bankers a tool to gauge whether the economy is running hot or cold. Policy makers consider where the economy is headed over the next 18 to 24 months, assess whether this direction will cause inflation to hit the target, and then try to speed up or slow down the economy by adjusting interest rates.

Canadian central bankers have added flexibility to this system over the years, allowing inflation to run higher or lower than the precise objective of 2 per cent within the bank’s target band, and adjusting the timeline over which they’re aiming to get back on track.

There is good reason to maintain flexible inflation targeting. The current regime has done a remarkable job of producing low and stable consumer price growth over the past 30 years.

But monetary policy has also faced escalating challenges since the 2008-2009 financial crisis. More than a decade of ultralow interest rates has encouraged a risky buildup of debt and left central banks with less room to stimulate the economy with rate cuts. This has forced them to introduce more unconventional policies, such as quantitative easing, and rely more on fiscal policy – government spending and taxation – to achieve economic goals.

These developments have also opened the possibility that a different inflation target or monetary policy objective could do a better job anchoring the currency and stabilizing the economy through different phases of the cycle.

Worldwide, other central banks are also soul searching. The U.S. Federal Reserve and the European Central Bank recently overhauled their mandates to address some of the structural problems caused by low interest rates, with the Fed moving to an average inflation targeting system as part of the dual mandate it has had since 1978.

“If there was ever a chance where there might be a more substantial change, this would be it. Not because of COVID, but because there has simply been more discussion in recent years, and I think appropriately, about possible changes in the mandate,” said Chris Ragan, economics professor and director of the Max Bell School of Public Policy at McGill University.

When the Bank of Canada started researching for the current mandate renewal in 2017, questions about inflation overshoots or quantitative easing were largely academic. The pandemic has brought these issues into focus.

Over the past 20 months, the bank has leaned into the flexibility of its existing mandate. It has promised not to raise rates until actual output in the economy has returned to its potential, guaranteeing an inflation overshoot into 2023.

Meanwhile, Mr. Macklem has emphasized an inclusive labour market recovery, arguing the bank’s inflation target cannot be sustainably achieved without full employment, and policy makers need to pay particular attention to the low-wage earners hit hardest by the pandemic.

The point of a mandate renewal is not to respond to the economic pressures of the day. The slow and methodical process that culminates in an agreement with the federal government every five years is aimed at producing something long-lasting and durable enough to manage multiple types of shocks. But could a change in mandate help bring the bank’s rule book in line with how it’s actually acted during the pandemic?

A dual mandate that targets full employment alongside inflation could give the bank more leeway to focus on employment metrics. Alternatively, an average inflation targeting regime would automatically hold down interest rates for an extended period coming out of a recession. The system looks to make up for low inflation during a downturn by aiming for higher inflation in the subsequent recovery.

Avery Shenfeld, chief economist of CIBC World Markets, doesn’t think the central bank will opt for a change. Its current flexible system already allows it to consider factors such as employment when making interest rate decisions.

“What the Bank of Canada is leaning to is basically clarifying that flexible inflation targeting includes all the wonderful features of any of these other systems that are being deployed,” Mr. Shenfeld said.

Toronto-Dominion Bank chief economist Beata Caranci has a similar assessment. “They could always remind the public that a deviation [from the 2-per-cent target] doesn’t mean a change in approach or mandate, because they’re actually still within their guidelines. If it isn’t broke, don’t fix it,” Ms. Caranci said.

At a news conference Thursday, Mr. Macklem said the bank learned a lot during the pandemic that will feed into the mandate renewal. But he did not tip his hand on where the bank might be going.

Some experts favour substantial change. Advocates of a dual mandate say an explicit directive to support full employment would force central bankers to think twice about tightening policy too quickly after recessions. That could benefit workers from marginalized groups, who tend to join the labour force late in a recovery. It could also help businesses and entrepreneurs, says Marc Lavoie, a professor of economics at the University of Ottawa.

“If you’re a business and you have a kind of guarantee that the central bank is not going to kill the economy whenever the rate of unemployment or the rate of utilization of capacity improves, then you might feel more confident to invest and go ahead with your projects,” Prof. Lavoie said.

The conversation around full employment has shifted in recent years, as a result of the weakening trade-off between unemployment and inflation. Economists refer to this as a flattening of the Phillips Curve, which is a crescent-shaped, downward sloping graph from high inflation on the top left to high unemployment on the bottom right.

For decades, unemployment was seen as a key predictor of inflation: When the unemployment rate fell too far, central bankers would raise interest rates in anticipation of inflation. But inflation appears to be less responsive to labour market tightness than in the past. This was especially noticeable in the years leading up to the pandemic, when unemployment in Canada and the U.S. reached 40-year lows without inflation taking off.

Economists aren’t sure why this is happening. Some point to a weaker wage bargaining position for workers in recent decades owing to declining unionization and the globalization of the labour market. Others suggest it has more to do with expectations of low inflation becoming ingrained as a result of credible monetary policy. Whatever the cause, the phenomenon is influencing central bank policy.

When the Federal Reserve updated its mandate in the summer of 2020, it revised its understanding of full employment. In practice, it means the Fed will consider keeping interest rates lower for longer than it might have in past cycles, with the aim of bringing more workers from underrepresented groups into the labour force.

A flatter Phillips Curve is not, however, a clear argument for the Bank of Canada to move to a full employment mandate. Mr. Macklem has already shown he’s willing to talk about full employment and work force inclusion within the context of the bank’s existing mandate.

And there are plenty of compelling reasons to steer clear of a Federal Reserve-style dual mandate, according to David Dodge, who was Bank of Canada governor from 2001 to 2008.

Policy makers should have one policy tool per policy goal, Mr. Dodge said in an interview. By trying to target price stability and full employment with a single mechanism – interest rates – central bankers are likely to miss both.

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Full employment is also a notoriously slippery number that cannot be precisely defined, and can only be implied based on inflation dynamics. The extreme amount of labour market disruption caused by the pandemic will make it even harder to estimate full employment in the coming years, he said.

“You can’t and shouldn’t set a hard number as to what your employment target is; that was precisely the problem we got into at the end of the 60s and in the 70s. We don’t want to get back into that problem,” Mr. Dodge said.

“Given what we’ve just been through in the past 18 months, there’s a very powerful argument for sticking with exactly the regime we have,” he said.

The Bank of Canada has gone through a mandate review every five years since 2001. From the outside, it can look like a largely technical exercise. Major changes are proposed and debated – raising the inflation target to 3 per cent, for example, or dropping it to 1 per cent. In the past, the status quo has always won out, with minor tweaks around the edges.

The reluctance to revamp the existing system owes much to its success over the past three decades. Since the bank and the federal government jointly adopted an inflation targeting regime in 1991, inflation has averaged just below 2 per cent, and inflation expectations have become well anchored, meaning inflation shocks tend to be shorter and less severe. One only needs to look back at the chronically high inflation of the 1970s and 1980s – a period of oil price shocks, monetary policy mistakes and double-digit inflation – to appreciate the hard-won benefits of inflation targeting.

But there are weaknesses in the system that emerged during the 2008-09 financial crisis and the decade of ultralow interest rates that followed.

“Central banks are likely to run out of conventional firepower if we see an economic downturn in a low-interest-rate world. Another challenge is that long periods of low interest rates encourage investors to take on risk that may be excessive,” then-senior-deputy-governor Carolyn Wilkins explained at a conference in August, 2020, laying out the bank’s research for the mandate renewal.

Lurking in the background is what economists call the “effective lower bound” problem. Central banks usually stimulate the economy by cutting their policy rate, which brings down short-term interest rates and trickles out through the economy by bringing down borrowing rates on everything from mortgages to car loans. But policy rates, in general, cannot fall below zero. Central bankers run out of room to cut rates to stimulate the economy, as happened during the financial crisis and again during the pandemic.

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The probability of hitting the effective lower bound has increased over the past two decades owing to a decline in interest rates. Economists speak about this in terms of a lower “neutral” interest rate: the one needed to produce stable inflation when the economy is operating at full capacity. In Canada, estimates of the neutral rate have fallen from around 5 per cent in the mid-2000s to the current range of 1.75 per cent to 2.75 per cent.

Central banks have little influence over the neutral rate. It’s mostly a function of demographics, technological change, productivity growth, and patterns of savings and investment. Nonetheless, central bankers need to conduct policy in relation to this neutral rate. Even if the Bank of Canada could get its policy rate back to the neutral rate in the coming years, it would have only limited room to cut rates next time the economy stumbles.

“The question is, do you deal with [the lower neutral rate] by raising the inflation target? Or do you deal with it by just becoming more comfortable with quantitative easing? Or do you deal with it by outsourcing your monetary policy to your fiscal authority?” Prof. Ragan said.

Policy makers have devised ways to ease financial conditions at the effective lower bound. These include forward guidance, in which the bank promises not to raise interest rates for an extended period; and quantitative easing, which involves buying massive quantities of government bonds in an effort to bid up their prices and push down interest rates – long-term ones in particular. (Bond prices and yields move in opposite directions).

These unconventional tools have proved fairly effective during the pandemic, but they remain stopgap measures that come with their own problems. QE, in particular, alters the functioning of financial markets and could reduce the bank’s room to manoeuvre in the future.

Does the current spike in inflation change much about these longer-term trends? Probably not, said Mr. Reitzes of BMO.

“As much as the transitory [inflation] narrative might be a little bit in doubt, you’re going to have a tough time finding anyone that expects 3 to 4-per-cent inflation in perpetuity,” he said.

“And there’s still longer-term factors in play – aging population, technological changes – that are disinflationary. And you can still look at Japan as maybe a proof point that disinflationary pressure may be ahead of us,” he said.

There is an emerging counterargument to the idea of long-run disinflation. Some economists say retiring baby boomers will reduce the labour force, and that could put upward pressure on wages. The disinflationary shock caused by China’s rapid integration into the world economy in recent decades might also dissipate. And the transition to a low-carbon economy could put upward pressure on prices of energy, as well as products produced using processes that emit less carbon.

Average inflation targeting is another response to the effective lower bound problem. Unfortunately, no amount of mandate fine-tuning is going to solve the problems caused by persistently low interest rates, which have put central banks in a bind.

“Now that we’ve been at the zero bound on and off for about 10 years, the fear is that you need to have rates very low to just achieve the central bank’s mandate of price stability,” Sylvain Leduc, former deputy governor of the Bank of Canada and now research director at the San Francisco branch of the Fed, said in an interview.

“And by keeping rates low you’re inducing risk to financial stability,” he said.

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Some economists suggest the Bank of Canada should do more to “lean” against financial stability risks, proactively raising rates to cool down asset price bubbles. But this involves a lopsided trade-off, Mr. Leduc said, with the bank sacrificing economic growth and price stability today for an unknown future benefit.

“Just in practical terms, if you’re around the table with the governing council of the Bank of Canada, and you’re saying, ‘We need to raise rates [to deal with financial stability risks].’ The next question is: How much? And do you need to raise them again at the next meeting, and again at the next meeting? If you do that it’s going to have an impact on the main part of your mandate at the bank, which is price stability,” Mr. Leduc said.

The only real way to manage financial stability risks is collaboration between the bank and other government organizations on what are known as macroprudential policies, Mr. Leduc said. This includes measures such as mortgage stress tests developed by the Canada Mortgage and Housing Corp. and bank capital rules put in place by the Office of the Superintendent of Financial Institutions (OSFI).

This same logic increasingly applies to economic stimulus as well. With less room to stimulate the economy with rate cuts, the bank must lean more on government fiscal policies to support the economy through downturns.

A key part of the current mandate review was looking at potential complementarities between fiscal and monetary policy. Bank researchers even studied the concept of using so-called Helicopter Money to stimulate the economy. The name comes from a playful example economists use: Governments print cash and drop it from helicopters. In practice, it means a central bank creates money directly to fund government spending, rather than having the government issue debt. But researchers rejected the idea.

The pandemic highlighted the bank’s willingness to work closely with the federal government during a major economic shock. Look no further than then-bank governor Stephen Poloz, then-finance minister Bill Morneau and then head of OSFI Jeremy Rudin sharing the stage at a joint news conference in March, 2020.

But the more the bank works with the government, the more defensive it may have to be about its independence and commitment to inflation targeting.

“The pandemic was a good example of that co-ordination,” said Ms. Caranci of TD Bank. “But I think you can push the boundary too far to the other side, where markets start to think that … your QE program is being supportive of government spending, so you’re doing an informal monetization of debt without saying you’re doing it.”

Ms. Caranci said questions from TD clients about central bank independence tend to focus on the Federal Reserve, which has been much slower than the Bank of Canada to start winding down its QE program. Canada’s central bank began slowing its bond buying a year ago, and will likely stop adding QE stimulus later this month.

“You want your policies to recognize the economic environment and be collaborative, but at the same time you have to still establish independence. And so I think [the Bank of Canada has] done a better job of that,” she said.

The swirl of questions – about firepower, central bank independence and labour market inclusion – give Mr. Macklem and Ms. Freeland a lot to chew on over the next few months as they work toward the mandate renewal. And that’s before even getting to issues such as the proper role of central banks in the green energy transition, or whether the bank should launch its own digital cash to remain at the heart of the payments system in a digital age.

“We need a framework that is robust to a broad range of circumstances. And really that’s what we will be focused on,” Mr. Macklem said.

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