For the Record : Assessing the Monetary Policy Stance of the Bank of Canada
This paper sets out to investigate two issues: first, it briefly provides a retrospective look at whether the stance of monetary policy was appropriate for hitting the Bank of Canada’s inflation target during 2018 and 2019, and second, it examines how to determine in real time whether monetary policy is too loose or too tight. This is the first edition of an annual assessment of the Bank’s monetary policy stance. The behaviour of inflation and other macroeconomic indicators in 2018 and 2019 supports the hypothesis that the Bank of Canada’s monetary policy over the past few years has been appropriate. Headline inflation in both years was very close to the Bank’s 2 percent target despite volatile conditions in the world economy. The slowdown in world economic growth in 2019, even before COVID-19, led the Bank to postpone its planned normalization of the overnight rate target toward the neutral rate, where economic output is at potential and inflation is on target. Our analysis of the real-time stance of monetary policy stops prior to the arrival of COVID-19. With the lack of room the Bank had to lower the overnight rate when the pandemic began, it is very likely any analysis in the middle of the COVID-19 crisis would indicate too tight a monetary policy stance. To establish the validity of our indicators, we thought it more appropriate to look at what they tell us about the monetary policy stance in more normal times. We find that different methodologies give different results about the stance of the Bank’s monetary policy at the end of 2019. Our analysis highlights the fact that measuring the monetary policy stance of a central bank is sensitive to the evaluative methodology. This is an important conclusion by itself, and suggests using an eclectic approach to evaluating monetary policy stances and multiple methodologies as robustness checks. This approach could also give an idea of the sensitivity of measures of the stance of monetary policy to underlying assumptions. By examining different aspects of the transmission mechanism, one could get a clearer picture of how monetary policy operates than through the black box of a general equilibrium forecasting model. By and large, this is how the Bank of Canada actually conducts its monetary policy: tempering the forecasts of its formal general equilibrium models with data from many sources and a fair degree of judgment. Evaluating its monetary policy stance next year, where the overnight rate is very likely to still be at the effective lower bound, will necessitate looking at other tools in its toolkit, such as forward guidance and quantitative easing