Economist breaks down the hits and misses of the central bank's approach
While the Bank of Canada’s forward guidance was well intentioned, the institution’s approach did not prove sufficiently adaptable to respond to the significant market volatility of the past two or so years, according to Beata Caranci, senior vice president and chief economist at TD Bank Group.
“The central bank should be forgiven for trying to inject calm and stimulate growth during a time of uncertainty,” Caranci said in a note earlier this week. “The mistake occurred when the Bank of Canada failed to evolve its guidance to the observable outcomes.”
The major shift came in the form of vaccines, which paved the way for a reopened – and revitalized – economy by the latter part of 2021.
“There was plenty of evidence that the economy had escaped the peak risk period and that sustainably achieving the 2% inflation target required edging up the policy rate from its crisis level,” Caranci said.
What derailed the forward-guidance approach was not the pandemic, Caranci said.
“It was because the Bank of Canada was steeped in a one-sided bias that anchored their views,” she argued. “They relied too much on past observations, rooted in a set of heuristics or rules that prevented the evolution of thought. Simply put, the BoC was overly biased to ‘what was’ rather than ‘what is’.”
The central bank fell into the trap of thinking that “playing it safe” meant leaving interest rates at emergency levels and ignoring how economic data has rapidly evolved.
“The burden of proof required the data to not just convince the central bank that it would succeed in its inflation mandate, but to erase every millimetre of doubt,” Caranci said. “This occurred despite the Bank’s analysis that noted the importance of considering government stimulus in setting monetary policy, and the impact of home prices on lifting household inflation expectations.”
What should be the Bank of Canada’s policy approach moving forward?
The central bank’s strategy should have a greater focus on household financial risks, which “should not have been so easily dismissed or punted to regulators to manage,” Caranci said.
“The consumer is king in the economy (i.e. >70% of GDP) and peer-country experiences have revealed household deleveraging cycles to be multi-year events that undermine long-term economic growth prospects,” she explained. “Regulators had already pulled on a half-dozen levers prior to the pandemic to manage housing financial imbalances, marked by changes in mortgage qualifications and amortization periods. The data had already shown this could only slow, but not stop the march of housing demand.”
And while it’s unlikely that the federal government would be able to offer again its unprecedented level of fiscal support for households, “a legacy will persist in the evolution of programs in response to economic shocks,” Caranci said.
“With more effective countercyclical fiscal policy, monetary policy should be more attuned to the pitfalls of leaving policy rates too low for too long.”
