Canada’s inflation-targeting central bank just acknowledged that inflation is headed above its 2-per-cent target in the post-COVID-19 recovery. And you know what? It’s okay with that.
The Bank of Canada had plenty of interesting – and, mostly, encouraging – things to say in its eagerly awaited interest-rate decision and quarterly Monetary Policy Report on Wednesday. It sharply increased its near-term economic growth estimates. It reduced its government bond-buying (aka quantitative easing) program by 25 per cent, citing the improved state of the recovery.
It now believes the economy will return to full capacity in the second half of 2022, rather than in 2023 as it had previously forecast. It talked optimistically about less scarring from the pandemic than previously feared, and about accelerated business investments in technology.
Amid all that upbeat news, the bank included a small table that contained, among other things, revised inflation projections. In that table, the bank projected that inflation in 2023 – a year in which it now expects the economy to be running at full speed – will be 2.4 per cent, modestly yet noticeably above the bank’s long-standing formal target of 2 per cent.
For those who track the Bank of Canada closely, this is a big deal. By convention, the central bank pretty routinely targets inflation two years into the future at very close to 2 per cent – because that’s the bank’s inflation target, and it’s understood that its monetary policy at any given time is designed to hit that target in the bank’s typical 18- to 24-month projection horizon. Now, the bank is effectively acknowledging that its current policy intentions – with its key interest rate on hold at a record-low 0.25 per cent at least until the economy returns to full capacity, expected in the second half of 2022 – are going to result not in reaching the inflation target, but in overshooting it.
In a nutshell, the central bank has quietly just signalled that it is prepared to let inflation run warm, if not exactly hot, in the postpandemic recovery – and that the arrival of 2-per-cent inflation will not necessarily trigger immediate interest-rate hikes to keep inflation on target.
Bank of Canada Governor Tiff Macklem certainly said nothing to dissuade this interpretation when discussing the inflation projection in his news conference Wednesday. He argued that because the bank has committed to keeping its key interest rate at its effective floor of 0.25 per cent until slack in the economy is fully absorbed – the point at which inflation should be sustainably achieve the 2-per-cent target – it’s inevitable that inflation would overshoot the target before rate increases can rein it in.
“We put in place that exceptional forward guidance because we were in a situation [last year] where we had a huge amount of excess supply in the economy, inflation was zero – in fact, it was negative for a little while,” he said. “We took out some insurance, to get [inflation] back to target quickly. The consequence of that is that the forecast has a small overshoot.”
“That’s part of flexible inflation targeting in a risk-management framework,” he said.
Indeed, while this is a change from the bank’s practice in recent years, it’s not a departure from its existing inflation-target mandate, which has flexibility baked into it. Officially, the bank operates its policy within a target band for inflation of 1 per cent to 3 per cent, with the 2-per-cent target being the sweet but sometimes elusive spot in the middle.
More than a decade ago, then-governor Mark Carney advocated flexibility around the inflation target as a valuable tool to the central bank in addressing major economic shocks, both in terms of the wiggle room implied by the target band, and in the time frame over which the bank typically aims to converge on its target.
Mr. Carney’s successor (and Mr. Macklem’s predecessor), Stephen Poloz, reminded Canadians of the flexible nature of the target, and its advantages in a crisis, from time to time during his tenure. But he viewed exercising that flexibility as, essentially, cashing in some of the credibility the bank has earned through decades of reliable adherence to the 2-per-cent target. A central banker wants to use it judiciously, he said, lest that inflation credibility become devalued.
Mr. Macklem is prepared to tap that credibility ATM. If ever there was a time to justify such a withdrawal, this crisis would be it.
One thing this implies is that even with the Bank of Canada now looking at the economy returning to full speed in the second half of 2022, it’s far from a given that interest rates will start climbing at that time. Mr. Macklem indicated Wednesday that that bank is looking for a “complete” economic recovery – and not just some arithmetic return to full output – before it begins returning rates to normal. That will include evidence that there has been a widespread recovery in the jobs lost to the pandemic, including low-income segments that were particularly hard hit by the crisis.
The flexible rate target affords Mr. Macklem the luxury of pursuing this sort of more robust and inclusive recovery even once inflation is bumping up against the bank’s 2-per-cent target, without feeling compelled to march rates higher. He’s signalled that this is a policy tool he’s more than willing to use.
Your time is valuable. Have the Top Business Headlines newsletter conveniently delivered to your inbox in the morning or evening. Sign up today.