Will the Bank of Canada Follow the Fed Into a New Inflation Targeting Regime?
- For the first time since 2001, the Bank of Canada (BOC) is seriously considering changing its existing mandate in an effort to better achieve its long-term inflation goals and preempt disinflationary risks to the economy.
- We expect to see qualitative adjustments to the BOC’s inflation targeting framework that are likely to result in a stronger commitment to reflation, and therefore a more measured and patient approach to tightening policy than we saw coming out of the global financial crisis.
- In our view, investors could potentially benefit from these changes by overweighting intermediate-term and real return bonds as alternatives to longer-term nominal bonds, and optimizing their portfolios to capture price appreciation through yield curve roll-down.
The Bank of Canada (BoC) is approaching a regular five-year review of its monetary policy objective, when it looks to renew the joint agreement between the bank and the government about the BoC’s framework. The 2021 review is likely to be particularly important. For the first time since 2001, the BoC is seriously considering changing its existing goals to make them more suitable to the persistent low-inflation, low-interest-rate environment Canada currently faces. To augment its current inflation target, the BoC is evaluating various alternatives via a “horse race” of potential alternative frameworks, including average inflation, price level, nominal gross domestic product (GDP) targeting, or a dual framework that would incorporate both prices and employment.
Still, we expect the BoC to reaffirm its existing flexible framework of inflation targeting and stop short of formally quantifying other objectives. However, while the framework itself may read the same, the BoC’s reaction function will likely be different from what we have seen in previous economic cycles. Specifically, we think the BoC will be significantly more measured and patient, raising interest rates only after seeing strong, persistent evidence of both inflation returning to target and the output gap closed, rather than preemptively hiking rates to prevent overheating. So, while the BoC is unlikely to follow the U.S. Federal Reserve in changing its framework, the implications for monetary policy are likely to be similar to the results of the Fed’s new monetary policy framework.
Why is a change in the framework being considered now?
After moving to an inflation targeting regime in 1991, the BoC has been relatively successful in meeting its objective, with inflation averaging a generally stable 1.9%. The BoC targets the 12-month change in consumer price index (CPI) inflation at the 2% midpoint of a 1%-3% inflation control range. Relative to other developed market central banks such as the Federal Reserve, the European Central Bank, and the Bank of Japan, the BoC has been much closer to achieving its inflation target over the past decade. Yet, more recently the BoC has been falling short of its objective, with annual inflation over the past five and 10 years averaging about 0.3%-0.4% lower than target (see Figure 1).
Figure 1: Bank of Canada has come closer to achieving its inflation targets than its peers.
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Source: Bloomberg; data is for periods from 1 April 2010 through 30, June 2020.