Bank of Canada raising rates to 0.75% – makes no sense

Most of Canada has heard that the Bank of Canada raised the short-term target interest rate from 0.5% to 0.75%, which was the first increase in about 5 years. The rate increase itself serves to increase a very small rate into another very small rate and is insignificant other than the fact that this sounds like it is a warning shot.

Indeed, when reading the Monetary Policy Report, I’ve come to the conclusion that there was really no justification for raising interest rates in accordance to the Bank’s mandate of maintaining inflation at a 1-3% band – their own research suggested that the economy was headed in that direction with the current monetary policy. The decision to raise interest rates appears to be completely arbitrary, or guided by other considerations that are not captured in the standard reports.

It is this scenario that makes me believe that barring any economically cataclysmic events, the Bank should probably raise again (to 1%), but for reasons that has nothing to do with maintaining a 2% CPI rate.

All in all, this policy decision by the Bank of Canada is mysterious.

3 thoughts on “Bank of Canada raising rates to 0.75% – makes no sense”

  1. So let me try to take a stab at this. The key sentence that you should be looking at with respect to this decision is “The neutral nominal policy rate in Canada is estimated to be between 2.5 and 3.5 per cent.”

    When you read the forecasts for the CPI in Table 2, those are numbers that are being spit out of a big economic model crunching away in the Bank of Canada headquarters (ToTEM, but LENS is being considered to replace it.)

    One of the things going on in the guts of ToTEM – along with assumptions about oil prices, how much the rest of the world wants our exports when exchange rates move, government spending, etc, is an assumption about how the central bank will behave in the future which belongs to a class of equations called ‘Taylor Rules’, where the Bank sets the interest rate depending on inflation, expected inflation, GDP, potential GDP, etc.

    The bank, and most economists, see 0.5% as foot pushing down on the gas pedal pretty hard. In the model, sustained monetary stimulus keeps pushing on economic activity. The model builds in that if 2.5-3.5% really is ‘neutral’ monetary policy, then anything less is expansionary and inflationary.

    The projection results you see, say for 2.1% CPI in 2019, are derived assuming that the Bank of Canada continues to act according to a dynamic rule governing managing the economy, that is moving the policy rate towards 3% as inflation moves to 2% and unemployment moves to, say, 6%. That is, they’re building in automatic tightening. Those forecasts are not derived from saying ‘what would the economy look like if the BoC stood still’.

    Consequently, what the model projections are actually saying to them are ‘everything is pretty okay now and things will keep on track to our 2% target as long as we take away the punch bowl before things get crazy (that is follow our estimated dynamic tightening policy)’ not ‘the current policy gets us to 2%’.

    Where you might reasonably be confused about the policy is if you don’t buy that 3% is neutral monetary policy in 2017, which is a very reasonable debate the profession is currently having. Here is a fairly readable introduction for the US. https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_brief/2015/pdf/eb_15-10.pdf, which suggests the natural real rate might be more like 0% these days, which would imply a neutral policy rate today of more like 1.5%.

  2. @Andrew: This was incredibly informative. Thank you. I was familiar with the Taylor rule in terms of setting interest rates. I see in the April report they also included this language, and projected a 2018 CPI of 2.0% and 2.1% for 2019. I wonder if this (rate increase) was all predictable well in advance.

    I don’t profess to be an expert on macroeconomics, but the collective actions of the US fed and the BoC (and perhaps the Eurozone coming) would suggest that the money sloshing around in the asset markets is going to get a bit more expensive in the upcoming year.

  3. @Sacha: I think it’s the timing that’s more up in the air rather than the trend. If nothing goes wrong over the next couple years then I expect to see a repeated series of raises coming out of both the Fed and the BoC. A lot of what I read seems to focus on the idea that maybe one hike will be six weeks earlier or later than estimated instead of ‘it’s very reasonable to expect five more hikes within two years’.

    The one thing that people never forget is the last crash. Just like there’s no shortage of people who’ve been looking for a repeat housing crash in the Canadian market, all the central bankers out there remember Greenspan being blamed for ‘keeping money too easy’ in the aughts, regardless of whether that’s true or not.

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