The art of monetary policymaking

Under normal circumstances, the framework surrounding monetary policy and how the Bank of Canada (BoC) makes its decisions attracts little attention, with the general public more concerned about when interest rates will change than how the decision is made. However, the surge in inflation during the post-pandemic period to levels not seen in decades, and the subsequent rapid increase in interest rates that followed have brought attention to how the BoC conducts monetary policy. With inflation and interest rates at their highest levels in decades, the central bank has come under attack; from the Conservative leader calling for the firing of the bank's governor, to premiers writing letters asking for restraint the fight against inflation. Even the finance minister publicly expressed relief as the BoC kept rates unchanged before quickly adding that she fully respects the central bank’s independence. Charles St-Arnaud is chief economist at Alberta Central. Photograph courtesy of Charles St-Arnaud While monetary policy benefits from a plurality of views, comments from politicians are unhelpful as the appearance of political meddling can undermine the central bank’s credibility and effectiveness. Monetary policy needs to be independent as it has been shown over many countries and years that elected officials have an “inflation bias”; i.e., an incentive to stimulate going into an election, and not be forceful enough to lower inflation when required. Therefore, while explicit policy recommendations should be avoided, discussions should be welcomed to improve the monetary policy framework. Similarly, many observers have called for lower interest rates in light of the impact on consumers. However, low inflation—as defined by the target—is the Bank of Canada’s policy objective. And as harsh as it may sound, it is not the role of the central bank to bail out borrowers who over-leveraged themselves when interest rates were low and have to face much higher payments now that interest rates have normalized. The BoC will only act if the situation leads to weaker growth and increased slack in the economy, which could push inflation below target. The inflation-targeting framework implemented by the BoC, developed in agreement with the federal government, directs the decisions of the bank, and has had a positive record since its inception in the 1990s. Is it perfect? No. However, just because it isn’t broken doesn’t mean there isn’t room for improvement. Does aiming for two per cent inflation still make sense? Some commentators during the recent inflationary episode questioned whether the target should be higher. However, this suggestion often comes with the view that, had the BoC target been higher, the central bank wouldn’t have needed to increase interest rates so aggressively. This view is fundamentally flawed since a higher inflation target would have been incorporated into the inflation process via inflation expectations, meaning that inflation would have been higher to start with, likely requiring the same amount of tightening. However, this is not to say that we shouldn’t discuss an optimal level of inflation. Inflation is to the economy what oil is to an engine: too little can be as damaging as too much. Some inflation allows for a nominal adjustment to shocks rather than via the real economy. What is the sweet spot, then? It is unlikely to be below zero per cent, and is very likely below five per cent. Some have argued that the BoC should have a broader mandate beyond inflation targeting, such as a full employment mandate; however, this has the potential to complicate decisions if both mandates suggest conflicting policies. Another possibility is to broaden the inflation objective beyond the current narrow focus on CPI inflation to include asset price inflation, credit aggregate growth, or other nominal variables. Since the inception of the inflation-targeting framework, private indebtedness levels and many asset prices have risen sharply. As this situation has led to important consequences for the economy—and likely unintended consequences of inflation targeting—further consideration could be necessary. Although whether an explicit broadening of the mandate is needed is far from clear, the current circumstances support the need for flexibility in monetary policy frameworks; this would allow the BoC to consider—at least implicitly—a broad array of considerations without being hamstrung by added policy constraints. After all, as monetary policy is more of an art than a science, it cannot be reduced to a simple Taylor rule. Charles St-Arnaud is chief economist at Alberta Central, the central banking facility and trade association for Alberta’s credit unions. He has worked as an economist for the Bank of Canada, the Department of Finance, and financial firms in New York, London, and Hong Kong. The Hill Times