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economy lab

Expectations play a key role in monetary policy: one of the main objectives – if not the main objective – of the Bank of Canada's 2 per cent inflation target was to anchor expectations of inflation, and this objective has largely been achieved: even when inflation fell below target during the worst of the recession, surveys of expectations for future inflation stayed steady at 2 per cent.

Being credible is one thing; being a crutch is another. Before the recession, private sector forecasters had come to rely heavily on the Bank of Canada's guidance, to the point where the Bank felt obliged to remind them that they should spend more time looking at the data and less time reading Bank of Canada press releases.

The flurry of activity in financial markets following yesterday's interest rate announcement suggests that they have not yet taken that advice to heart. Even before the release of the strong March employment data, the GDP data from the fourth quarter of 2011 showed a continued closing of the output gap. The April, 2012, Monetary Policy Report released Wednesday estimates that the gap closed from 0.7 per of GDP in the fourth quarter of 2011 to 0.4 per in the first quarter of 2012

Forecasters around the world have been busy in the last few weeks revising up their estimates for Canadian economic growth. This improved outlook combined with an inflation rate that is already drifting above target should have been a clear signal that the Bank of Canada would be move to raise interest rates earlier than it may have been intending to in January.

I really don't understand how financial markets could have been so surprised by the wording of yesterday's interest rate announcement. They knew that the facts had changed; they should have known that the Bank of Canada's policy stance would change as well.