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The COVID crisis should destroy once and for all the notions that interest rates can be set by math alone.
Tiff Macklem, the new Bank of Canada governor, used his first speech to defend the central bank’s commitment to inflation targeting, a regime he helped design as a young researcher in the late 1980s.
“The message I want to leave you with is that while we are using different tools in these extraordinary times, our policy remains grounded in the same framework,” Macklem said. “The inflation target is our beacon that is guiding our actions as we help bring the economy from crisis, through reopening, to recuperation and recovery.”
That’s a more controversial declaration than it might sound. There is a rich debate in academia over whether inflation targeting still works as well as practitioners had come to believe.
The contrarians raised enough doubt that many central banks, including the Bank of Canada, are taking a hard look at the way they set interest rates. In fact, Macklem will have to make a call next year on whether to stick with the current inflation-targeting regime or recommend to the government that they adopt something else.
For now, Macklem is signalling that he has no doubt about the power of keeping inflation low and stable. But he does have concerns about the way the central bank tracks inflation, as a few months of lockdown might have disrupted spending patterns to the point that the main gauge — the Consumer Price Index — is currently unreliable.
“Total CPI is weighted to reflect the buying patterns of the average Canadian household,” Macklem said. “In normal times, for example, Canadians spend a lot more on gasoline than on alcohol, so gasoline has a larger weight in the index. But these aren’t normal times.”
They don’t have as much influence as they used to, but some economists think interest rates should be largely determined by mathematical equations involving variables such as the CPI and economic growth. Such a rigid approach could lead to bad outcomes at times like these when the variables have veered from trend.
The CPI decreased 0.4 per cent from May 2019, the second consecutive decline. Does that mean Canadians are experiencing deflation? Probably not, because much of the downward pressure is coming from gasoline prices and most Canadians haven’t been driving very much. Still, weaker inflation is in line with a recession, so the signal remains relevant, but it’s not telling policy-makers how much extra stimulus could be required.
“Bank staff have been working with Statistics Canada to better understand the implications of these shifts in spending patterns,” Macklem said. “As the economy reopens, many of these shifts will unwind. We will be working to look through temporary shifts while capturing any more enduring changes.”
In the meantime, Macklem and his deputies will rely more on instinct and less on their dashboard. Next month, the central bank will release a “central scenario” of where it thinks the economy is headed, rather than its typical quarterly forecast.
“We expect the quick rebound of the reopening phase of the recovery will give way to a more gradual recuperation phase, with weak demand,” Macklem said. “If, as we expect, supply is restored more quickly than demand, this could lead to a large gap between the two, putting a lot of downward pressure on inflation.
“Our main concern is to avoid a persistent drop in inflation by helping Canadians get back to work.”
Copyright Postmedia Network Inc., 2020