The New Republic magazine once suggested that “Worthwhile Canadian Initiative” was “the most boring headline ever written.” It is often said that good central banking should be boring. So perhaps the Bank of Canada (BoC) would be delighted to have its policy decisions reported under such a headline.
However, Canada’s central bank has recently become very interesting to those trying to understand how central bankers make their decisions.
Canada is the fourth-largest oil exporter in the world, which means the huge fall in the price of oil over 2014 and 2015 represented a significant negative shock to the Canadian economy. In response, the BoC cut interest rates twice in 2015, from 1% to 0.5%, to help support the economy’s adjustment away from the energy sector.
At the time, Governor Stephen Poloz described the cuts as “insurance” against the oil shock and the possibility of an even more severe downturn, with a bias to further rate reductions if the economy deteriorated.
Until April this year, the BoC maintained its easing bias, and its communications generally pointed in a dovish direction. It stressed caution over labor-market slack, export underperformance, lack of inflation and wage growth, and policy risks stemming from the U.S. However, by June, Governor Poloz was clearly signaling that a rate hike would be forthcoming, noting that the cuts “have done their job.” It came as no surprise to most investors when the BoC decided to raise its policy rate from 0.5% to 0.75% in July.
Canada’s recent growth performance has been strong, and the worst of the oil-price shock seems to have passed. However, there still appears to be slack in the Canadian labor market, and inflation is running well below the BoC’s 2% inflation target. This would typically support a continuation of easy policy. Some investors have suggested that the BoC’s recent hike doesn’t really represent a typical interest-rate hike done for standard monetary-policy reasons. Instead, the BoC could have been removing the insurance it took out in 2015. Once this now unnecessary insurance is removed, on this reasoning, the bank will cease its hiking cycle.
Canada’s recent growth performance has been strong, and the worst of the oil-price shock seems to have passed.
It isn’t only Canadian central bankers who may be thinking along these lines. Chief Economist at the Bank of England (BoE) Andy Haldane, has also framed the BoE’s August 2016 easing package – announced in the wake of the Brexit referendum – in similar insurance terms. He has suggested that the BoE’s first hike would simply be a removal of this insurance, which perhaps should be thought of as different from a normal hike.
At first glance, the language of insurance might sound like a peculiar way to frame a policy decision. Typically, insurance is the protection against something that is unlikely to happen. In contrast, we tend to think of central banks setting policy in response to their views on how the economy is most likely to evolve, not on risks they consider less likely.
When the risks the economy faces are broadly balanced around what a central bank views as the most likely outcome, its risk-weighted forecast and its forecast for the most likely outcome are fairly similar. However, a significant gap can open up between the most likely and risk-weighted outcomes when the risks become skewed either to the upside or the downside.
For example, back in 2015, the BoC may have thought a further decline in the price of oil was highly unlikely, but that if it did occur it would have had a huge negative impact on the economy. As a result, the BoC’s risk-weighted outlook would have become skewed in a more negative direction.
What does this mean for policy making? If a central bank sets its policy on the basis of a risk-weighted forecast, it may follow a different policy path than it would were it only focusing on its most likely view. This is how big downside risks could justify insurance cuts.
If the central bank then came to judge that the risks that triggered its insurance cuts have diminished, but that its central forecast for how the economy is most likely to evolve has not really changed, this could justify a hiking cycle that simply removes the insurance cuts – but goes no further.
This is not, however, exactly how the BoC is viewing its decision. When asked if the July hike was part of the removal of insurance or the launch of a tightening cycle, Poloz said that there is “no simple answer.”
He went on to stress the BoC’s view that the recent weakness in inflation is transitory and that the output gap will soon close. Given the lags in monetary policy, on this view, the BoC has to start tightening in anticipation of higher future inflation. This sounds a lot like normal monetary policy reasoning, rather than a central bank wishing only to remove its insurance with a “two hikes and done” cycle.
Nonetheless, this risk-weighted approach is a useful way of thinking about central-bank behavior. It certainly helps explain the very gradual strategy that the major central banks have suggested they will adopt when they do eventually start raising rates – or, in the case of the U.S. Federal Reserve (Fed), are already adopting.
Because central banks struggle to ease policy further when interest rates fall close to zero, hitting the lower bound can cause sustained periods when monetary policy is simply not stimulating the economy enough. These periods can be extremely costly in terms of lost output and unemployment. Falling back to the zero lower bound is effectively a high-impact event, which skews the central bank’s risk-weighted forecast, and may justify an easier path of policy than the most likely outcome would.
The Bank of Canada reminds us that there are many reasons why a central bank may want to change its policy stance. If investors only focus on how a central bank’s most likely forecast for the economy is changing, they may miss how the emergence of high-impact risks can cause policy to switch, with policymakers suddenly wanting to take out insurance. Accordingly, investors would be wise to consider the full balance of risks when forecasting central-bank behavior and the path of interest rates.
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