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The Bank of Canada's decision to maintain its target for the overnight rate at 1 per cent probably took few by surprise: a Reuters poll found that all forecasters contacted were expecting the Bank to take no action. But holding rates constant was by no means the certainty that the markets seemed to think, even before yesterday's strong GDP numbers.



The Bank of Canada's job is really quite straightforward, if not exactly simple: keep inflation at its target of 2 per cent. This is not bureaucratic boilerplate; Bank officials will tell you the same thing both on and off the record. Policy debates are about how that target can be attained.

The basic framework for Canadian monetary policy is familiar to those who have taken an intermediate macroeconomics course. When output is at potential, there are no inflationary pressures, and the Bank tries to set interest rates at a neutral rate. Inflationary pressures occur when output goes above potential, and bank responds by seting rates above the neutral rate. And if output falls below potential, the Bank sets interest rates below the neutral rate.



Although the Bank doesn't publish its estimate for the neutral rate, it would appear from past experience that it lies somewhere around 3.0-3.5 per cent: previous decisions have set interest rates above or below this range according to whether or not output was above or below potential. What the bank does publish are its estimates and its forecasts for the output gap between actual and potential. Current output is still below potential, so the Bank is comfortable with an overnight target below the neutral rate.



But the Bank's latest Monetary Policy Report also projects that the output gap will be closed by the end of 2012, so it must presumably be planning to increase interest rates to the 3.0-3.5 per cent range over the next two years. The Bank generally changes its overnight rate target by increments of 25 basis points, so going from 1 per cent to 3 per cent requires 8 increases over the space of 14 announcements before the end of 2012.



The 2012 deadline is of course not set in stone; events could well push the closing of the output gap into 2013. But after four consecutive decisions to hold interest rates constant and yesterday's strong GDP release, the odds of future increases can only increase: the Bank doesn't want to raise interest rates all at once and at the last minute.













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.



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