Expect tweaks not big changes as the Bank of Canada gets closer to new interest rate policy

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For the better part of three decades, the men and women in charge of interest-rate policy at central banks have tended to trust one indicator to guide their decisions: inflation. Prices remain their North Star, but the sky is getting busier.

In 2019, the Reserve Bank of New Zealand, which in 1989 became the first central bank to adopt a formal inflation target, was told by Jacinda Ardern’s government to include “maximum sustainable employment” as an objective. Earlier this year, Ardern added “sustainable house prices, including dampening investor demand for existing housing” to governor Adrian Orr’s agenda.

Elsewhere, the United States Federal Reserve last year said it would aim to achieve average inflation of about two per cent over a period of time, rather than keep the rate of increase locked at a cruising speed of two per cent. The European Central Bank is in the process of reviewing its policies and its president, Christine Lagarde, seems keen to take on a bigger role in the fight against climate change. Boris Johnson’s government in the United Kingdom has already decided to put the Bank of England closer to the front lines, informing the central bank earlier this month that its purchases of corporate bonds must now consider the “climate impact of the issuers.”

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Canada’s central bank is also rethinking things.

Governor Tiff Macklem in an interview on March 31 said that he and his deputies were on track to give policy recommendations to Finance Minister Chrystia Freeland in the “second part of the year,” which would align with the end of the Bank of Canada’s current mandate from the government. “There have been some discussions (with Finance) at a working level, but not at a senior level,” he said.

There’s a randomness to what’s been happening abroad, especially in New Zealand, where the central bank appears to have become the government’s answer to difficult problems. There is a maxim in central banking that the benchmark interest rate is too blunt to achieve more than one goal, never mind three.

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Canada’s review of monetary policy is more structured than those of its peers. The central bank gets revised marching orders from the finance minister every five years, although that mandate is heavily influenced by the Bank of Canada’s internal assessments of the optimal way to set interest rates.

The government has done little but tweak monetary policy since the current approach to inflation targeting was adopted in the early 1990s. The bar for change is extremely high, but policy-makers have approached the current review with an open mind.

After going through the motions ahead of the 2016 renewal, the Bank of Canada has this time around set a new standard for transparency. Carolyn Wilkins, who retired as senior deputy governor in December, took control of the process, hosting a conference in 2017 to begin gathering ideas. There have been other events since. Wilkins also made an effort to give the general public a chance to participate, setting up surveys and focus groups to get feedback on inflation and interest rates.

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Macklem did a couple of interviews this week to amplify the release of some of that survey data. Focus groups tended to have positive things to say about the status quo, although pollsters expressed surprise at how often “economic polarization” came up, a sensitive subject for central bankers, as some research concludes that relatively wealthy owners of houses, equites and other assets have disproportionately benefited from low interest rates.

At the same time, the sessions discovered that “many” people didn’t know why the Bank of Canada’s inflation target was two per cent, and some didn’t understand the link between inflation and employment. Even though the current policy received little negativity, there were nonetheless constant doubts expressed about whether the Bank of Canada’s preferred measure of inflation, the Consumer Price Index (CPI), was too broad to capture the reality of most households.

“Canadians are cognizant that inflation hurts others differently,” Macklem said. “That is informing our research agenda. We are working with Statistics Canada on getting measures of inflation that are targeted more to specific groups. That has come directly out of speaking with Canadians.”

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To be clear, the Bank of Canada isn’t on the verge of crowdsourcing its approach to setting interest rates. The public might dislike CPI, but the governor demurred when asked if that meant he might consider a different target. “I’m not going to speculate on that,” he said. “The CPI has a lot of advantages at the end of the day … The CPI is the broadest measure of the cost of living.”

But the survey results could influence the choice of policy regimes. One of the reasons inflation targeting works fairly well is that it’s easy to understand. Policy-makers worry that if consumers and businesses lose confidence in the central bank, they also will lose confidence in assurances from Ottawa that they needn’t worry about rising prices. Uncertainty, in theory, could trigger an inflationary spike.

Nevertheless, the central bank’s polling discovered that the public could be persuaded to get behind two of the new policies the Bank of Canada has been testing: average-inflation targeting like the Fed does (the Fed also aims to achieve “maximum employment” along with stable prices), and a dual inflation/employment target like New Zealand.

The prospect of public acceptance removes a barrier to making a change if the Bank of Canada’s research supports it, and the government is willing to go for it. “There was a real interest in making sure our inflation-targeting framework had a focus on employment,” Macklem said.

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