BoC’s commitment to data-based interest-rate policy a welcome shift

Policy experts laud central bank's departure from forward guidance, warn of miscommunication risks

BoC’s commitment to data-based interest-rate policy a welcome shift

While the most recent 4.25% increase in interest rates by the Bank of Canada was expected, the change in the central bank’s tone during the announcement is particularly noteworthy, according to two policy experts from a prominent think tank.

In an open letter to the Bank of Canada Governing Council, Steve Ambler and Jeremy M. Kronick of the C.D. Howe Institute said in stark contrast to the BoC’s prior 2022 predictions that more rate rises were unavoidable, it stressed that more tightening will "depend on the data."

That provides the Bank greater leeway in a very ambiguous environment, allowing it to pause and reflect while its rate rises spread across the economy. In other words, it can avoid the potential problems associated with making definitive statements.

As an example, Ambler and Kronick cited the second half of 20202, when the overnight rate was at its lower bound. At the time, the BoC told Canadian consumers and companies that low interest rates would likely last for a very long time, hoping to increase demand and battle low inflation.

The two argued that attempt at forward guidance – when a central bank aims to provide predictability for individuals and organizations to confidently move forward with significant scheduled purchases and investments – only added to increasing inflation and an overheated economy that the central bank is now trying to cool.

Many Canadians who accepted the advice to take out mortgages at all-time low rates are now facing significantly higher borrowing costs. While some people have not seen adjustments in their mortgages yet, the pinch will eventually come for them as well.

While people make spending decisions that hurt the economy and themselves because they believe the central bank will stay on its previously revealed course, forward guidance does not mean it will adhere to a fixed plan.

When headline inflation was still significantly below target two years ago at 0.7%, the Bank declared it would maintain the policy interest rate at the effective lower bound until the economy's excess slack is absorbed and the 2% inflation objective is stably attained. However, Ambler and Kronick said, this commitment hinged on the output gap, or the difference between the economy's actual and potential production.

“The Bank’s two calculated output-gap indicators remained negative at the end of the third quarter of 2022 (-2.1 and -0.4 percent),” they said. 

While there was a need to deviate from that forward guidance, doing so jeopardizes the tool’s credibility, which the two said might have been part of the reason why the BoC held off on hiking rates.

There are similar risks as interest rates increase on the tightening side, they added, as excessive forward guidance prompts excessive dampening economic activity dampening. The central bank's pledge to rely more heavily on data, the two argued, is even more appropriate given its signals of an expected end to the tightening cycle.

“It is true that headline inflation still looks stubbornly high, at 6.8 percent in November,” they said. “On the other hand, as we have previously pointed out, the built-in inertia of this metric does not readily reflect the current situation, which is actually starting to look better.”

Aside from committing to a greater data focus, Ambler and Kronick urged the central bank to fixate less on headline inflation, and instead “use the more telling measures that exist.”