Monetary Policy Framework Renewal (December 2021)

Contents

Chapter 1: Introduction .......................................1

Chapter 2: Canada’s experience with

inﬂation targeting

..............................................7

Chapter 3: Key challenges for the conduct

of monetary policy

...........................................20

Chapter 4: Lessons from a comparison

of alternative frameworks

....................................33

Chapter 5: Overview of monetary policy tools.............48

Chapter 6: Strengthening the conduct

of monetary policy

............................................65

Monetary Policy

Framework

Renewal

December 2021

Chapter 1: Introduction

Building on success

Every five years, the Bank of Canada and the Government of Canada review

and renew the agreement on Canada’s monetary policy framework. In 2021,

the country’s flexible inflation-targeting framework was renewed for another

five-year period, ending on December 31, 2026.

The Government and the Bank believe that the best contribution of monetary

policy to the well-being of Canadians is to continue to focus on price stability.

The Government and the Bank also agree that monetary policy should

continue to support maximum sustainable employment, recognizing that

maximum sustainable employment is not directly measurable and is

determined largely by non-monetary factors that can change through time.

Further, the Government and the Bank agree that because well-anchored

inflation expectations are critical to achieving both price stability and

maximum sustainable employment, the primary objective of monetary policy

is to maintain low, stable inflation over time.

Under this agreement, the Bank will continue to conduct monetary policy

aimed at keeping inflation—as measured by the 12-month rate of change in

the consumer price index—at 2 percent, with an inflation-control range of

1 to 3 percent.

This agreement also articulates how the Bank can continue to use the

flexibility in its framework to manage the challenges of lower neutral interest

rates globally and uncertainty about maximum sustainable employment. As

such, it provides continuity and clarity and strengthens the framework to

reflect the realities of the world we live in.

Flexible inflation targeting has delivered low, stable and predictable inflation

since it began in 1991. This has contributed to a more stable environment in

which households and firms can make spending and investment decisions. It

has also contributed to sustained growth in output, employment and

Monetary Policy Framework Renewal | 2021 | Page 2

productivity and has improved Canadians’ standard of living. The 2021

reopening of the global economy has been associated with elevated inflation

in Canada and abroad. While this is a global phenomenon, it makes

maintaining a sound framework for monetary policy in Canada all the more

important.

Every time the agreement is renewed, the Bank carefully reassesses whether

the existing monetary policy framework is the best contribution that the Bank

can make to promoting Canada’s economic and financial welfare.

The 2008–09 global financial crisis and the COVID-19 pandemic have had a

significant impact on the global economy and financial system, and major

trends such as shifting demographics and new digital technologies are

altering the economic landscape. Climate change and the long-term transition

to net-zero greenhouse gas emissions will drive structural change in the

Canadian and global economies. Also, there is now greater recognition,

supported by economic research, that when the benefits of economic growth

and opportunity are more evenly shared, it leads to more prosperity for the

whole economy.

A strong and inclusive labour market helps reduce income

inequality and supports robust demand for goods and services.

Leveraging the flexibility of the framework

These trends emphasize the importance of the flexibility inherent in Canada’s

monetary policy framework. Two of them are particularly relevant:

 Neutral interest rates around the world—which ensure that demand is in

line with an economy’s long-run productive capacity—are lower than in

the past and will likely remain low in the future. This means that central

banks will have less room to lower the policy rate in response to negative

shocks. As a result, the Bank will likely have to use other monetary policy

tools more often and may need to hold interest rates low for longer.

 Major forces such as shifting demographics, technological change,

globalization and shifts in the nature of work are having profound

effects on the Canadian labour market. This means there is increased

uncertainty about the level of maximum sustainable employment. In other

words, it has become more difficult to pin down the highest level of

1 See, for example, Macklem (2021) as well as Hsieh et al. (2019) and Ostry et al. (2018).

Monetary Policy Framework Renewal | 2021 | Page 3

employment that the economy can sustain before inflation pressures

build.

To manage these challenges, the Bank will continue to leverage the flexibility

inherent in its framework. Specifically, when conditions warrant, the Bank will:

 use a broad set of monetary policy tools, as well as the 1 to 3 percent

inflation-control range, to deal with the likelihood that the Bank’s policy

rate will be at its lowest possible level more often.

 actively seek the level of maximum employment needed to sustainably

achieve the inflation target. The Bank will consider a broad set of

indicators to gauge the health of the labour market and to inform its

assessment of the economic outlook.

The Bank will use the flexibility of the 1 to 3 percent range only to an extent

that is consistent with keeping medium-term inflation expectations well

anchored at 2 percent. And the Bank will clearly explain when it is using that

flexibility.

The Bank will continue to assess financial system vulnerabilities, recognizing

that a low interest rate environment can be more prone to the development

of financial imbalances. A variety of other policy instruments, such as

macroprudential tools, are better suited than monetary policy to address

these vulnerabilities. But because monetary policy can exacerbate financial

vulnerabilities, the Bank will continue to be mindful of the risk that such

vulnerabilities can lead to worse economic outcomes down the road.

Climate change poses substantial risks to the global and Canadian economies.

While monetary policy cannot directly tackle the threats posed by climate

change, the Bank will develop the modelling tools needed to take into

account the important implications of climate change on the Canadian

economy and financial system.

Conducting a more in-depth and comprehensive

review

Past reviews of the inflation-control target agreement have included serious

consideration of some alternative frameworks. However, the Bank has not

performed a systematic comparison of a full range of alternatives since it

adopted inflation targeting. For this latest review and renewal, the Bank used

a combination of model simulations, lab experiments and public consultations

Monetary Policy Framework Renewal | 2021 | Page 4

to run a “horse race” of key alternatives to inflation targeting, weighing the

pros and cons of each:

 average inflation targeting

 a dual mandate, targeting both inflation and employment

 nominal gross domestic product (NGDP)—both level and growth—

targeting

 price-level targeting

In this horse race, the current flexible inflation-targeting framework, along

with average inflation targeting and a dual mandate, did better than other

approaches that represent larger departures from the status quo. While

neither average inflation targeting nor a dual mandate was judged to be

better overall than the current approach, the Bank found value in some

elements of each of these two alternatives. The Bank’s research concluded

that the inflation-targeting framework is flexible enough to mimic these key

elements without the drawbacks associated with the alternative approaches.

Listening to Canadians

The Bank also significantly expanded its outreach activities to include public

consultations with Canadians and discussions with a broader set of

stakeholders and interest groups. Since the 2008–09 global financial crisis,

central banks have implemented extraordinary policies and used a variety of

new tools—putting central banks in the public eye more than ever. The Bank’s

recent public outreach was an important opportunity to assess the economic

environment, gather input and ensure that the Bank’s policies and decisions

reflect the views of the people it serves. This, in turn, reinforces public trust. As

well, gathering a more diverse range of views on the Bank’s activities,

decisions and frameworks—and on alternatives—ultimately leads to better

policy outcomes.

Through these consultations, which took place in 2019 and 2020, the Bank

aimed to:

 gain a better understanding of the concerns Canadians have about the

economy and economic policy

 learn how the existing framework affects different groups of Canadians

and how the alternative approaches might affect those groups

Monetary Policy Framework Renewal | 2021 | Page 5

 assess how well people understand the different monetary policy

frameworks and their trade-offs, since these frameworks are more

effective if Canadians understand them well

 gauge people’s awareness, understanding of and support for

unconventional policy tools such as forward guidance and quantitative

easing

The consultations and subsequent public opinion research demonstrated that

Canadians are broadly confident in the Bank’s ability to keep inflation low and

stable, and that public trust in the Bank and the financial system would

remain steady through the COVID-19 pandemic. Continued engagement and

clear communications with Canadians will be required as the Bank navigates a

period of above-target inflation as a result of the unique characteristics of the

economic reopening and recovery from the pandemic.

Many Canadians were open to some change in the Bank’s approach but

generally supported the continued use of inflation targeting. Most viewed the

current inflation-targeting framework as balanced, flexible and the most easily

understood approach. Of the alternatives, a dual mandate received some

interest—reflecting a desire by many Canadians for the Bank to consider how

it could support the labour market—but many questioned whether an

employment target would be achievable. Canadians also indicated an interest

in average inflation targeting, which suggests a desire for more flexibility in

how the Bank achieves the 2 percent target. The other frameworks—price-

level targeting and NGDP targeting—were seen as less achievable or harder

to understand.

The majority of participants emphasized the importance of the Bank being

flexible in how it achieves the inflation target. Specifically, Canadians were

most comfortable with an approach that targets a range for inflation and

adjusts interest rates slowly to achieve the target. Many were open to

accepting longer periods of above- or below-target inflation to support the

economy and jobs.

Outlining the road to renewal

This background document describes the research and analysis that

supported the new agreement on Canada’s monetary policy framework.

Monetary Policy Framework Renewal | 2021 | Page 6

Chapter 2 discusses Canada’s experience with inflation targeting. Chapter 3

explores the key challenges in conducting monetary policy given the shifts in

the economic landscape. Chapter 4 provides a detailed discussion of the

Bank’s comparison of alternative policy frameworks. Chapter 5 examines the

full range of monetary policy tools available in the Bank’s tool kit. Finally,

Chapter 6 outlines how the Bank will conduct monetary policy under the

renewed agreement.

Monetary Policy Framework Renewal | 2021 | Page 7

Chapter 2: Canada’s experience

with inflation targeting

Over the past 100 years, Canada has used several monetary frameworks.

These have included the gold standard, the Bretton Woods system of pegged

exchange rates, monetary targets and, since the early 1990s, inflation

targeting.

Canada first announced an inflation target in February 1991. After the target’s

introduction, inflation, as measured by the consumer price index (CPI), came

down quickly, and since the late 1990s it has generally been low, stable and

predictable (Chart 1). This stands in sharp contrast to the high inflation of the

1970s and early 1980s.

Inflation spent periods below the 2 percent target during the 2008–09 global

financial crisis and the 2014–15 collapse in commodity prices and, in 2020–21,

during the COVID-19 pandemic. As a result, average inflation following the

global financial crisis up until the pandemic was below 2 percent.

The COVID-19 shock presented unique challenges for monetary policy. The

widespread closure of many sectors of the economy was met with aggressive

fiscal and monetary policy stimulus. This stimulus supported a faster, albeit

-20

-15

-10

-5

1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 2015

Inflation-control range CPI inflation Inflation target

Chart 1:

Introducing inflation targets brought inflation down

-month rate of increase, monthly data

Last observation: October 2021

Sources: Statistics Canada and Bank of Canada calculations

Inflation

targeting

Monetary target and

other frameworks

Gold standard

framework

Bretton Woods

system

Bank begins

operations

Monetary Policy Framework Renewal | 2021 | Page 8

uneven, recovery. The strong global recovery, particularly in the demand

for goods, exacerbated supply constraints and higher energy prices. This

led to an average inflation rate of goods in the first 11 months of 2021 of

4.4 percent, well above that of services at 2.1 percent. This contrasts

sharply with recent trends: over the 20 years before the pandemic, goods

inflation averaged only 1.4 percent while inflation for services was 2.4

percent. This rapid rise in inflation for goods was the key driver in above-

target inflation during 2021.

Notwithstanding periodic macroeconomic shocks such as the one Canadians

are experiencing as a result of the COVID-19 pandemic, Canada’s flexible

inflation-targeting framework has kept inflation low, stable and predictable

for three decades. It has been robust to a variety of economic circumstances

and has enhanced welfare by fostering a more certain environment where

planning for the future is easier.

Three key factors have contributed to the framework’s success (Carter,

Mendes and Schembri 2018):

 The inflation target is straightforward to explain and understand. This has

improved accountability and allowed consistent application of the

framework over time.

 The framework is based on an agreement between the Bank of Canada and

the Government of Canada. The joint agreement grants the Bank operational

independence to achieve the inflation target, while emphasizing that inflation

control ultimately remains a shared commitment of both parties. The

agreement also gives the target democratic legitimacy, further enhancing the

target’s credibility and helping to anchor inflation expectations.

 The regular, formal and transparent review and renewal process leads to

continual improvement of the framework and its implementation. This

process allows the Bank to incorporate lessons learned from historical

experience and research.

Each renewal cycle has involved analysis of a range of issues. For instance,

during the 2016 cycle, the Bank focused its review and research on the

following three questions:

 Should the 2 percent inflation target be increased?

Gravelle (2021b) offers a discussion on the role of energy prices, shifts in demand across goods and supply

constraints on consumer prices over 2021.

Monetary Policy Framework Renewal | 2021 | Page 9

 To what extent should the conduct of monetary policy consider financial

stability?

 How should core inflation be measured and used as an operational guide

for the conduct of monetary policy? (Box 1 presents an updated

assessment of the core measures.)

Box 1:

An updated assessment of the core measures

The inflation target in Canada is expressed in terms of consumer price index (CPI)

inflation. Monetary policy achieves the inflation target by influencing domestic

demand for goods and services, which, in turn, affects underlying inflationary

pressures. Many other factors can also influence CPI inflation—for example, changes

in the prices of commodities, which are set in global markets. Because the price

movements are likely to be short-lived and the effects of monetary policy on inflation

are delayed, the Bank of Canada focuses on the underlying rate when making policy

decisions. It also uses forecasts for CPI inflation that go beyond the horizon of the

temporary factors.

For the 2016 renewal of the

inflation-control agreement,

the Bank replaced CPIX

inflation as its preferred

measure of core inflation.

adopted three other measures

that performed well across a

range of evaluation criteria—

CPI-common, CPI-trim and

CPI-median (Chart 1-A).

Using these three indicators of

inflation over the past five

years has helped the Bank

manage the risks associated

with relying on any single

indicator.

3 CPIX inflation excluded eight of the most volatile components of the CPI (fruit, vegetables, gasoline, fuel oil,

natural gas, mortgage interest, intercity transportation and tobacco products) and adjusted the remainder for the

effect of changes in indirect taxes.

4 CPI-common uses a statistical procedure to track common price changes across categories in the CPI basket. CPI-

trim excludes upside and downside outliers. CPI-median is the median inflation rate across CPI components. For

details, see Bank of Canada (2016) and Khan, Morel and Sabourin (2015).

1990 1995 2000 2005 2010 2015 2020

CPI-common CPI-trim CPI-median

Chart 1-A: Measures of core inflation have

provided a useful guide for monetary policy

Year-over-year percentage change, monthly data

Last observation: October 2021

Sources: Statistics Canada and Bank

of Canada calculations

Monetary Policy Framework Renewal | 2021 | Page 10

From 2017 through 2019, the dynamics of all three measures were consistent with an

economy where slack had largely been absorbed—all were within a narrow range

and close to 2 percent. The use of these measures as a guide for monetary policy was

tested more recently because of the uneven economic impacts of the pandemic. The

three core inflation measures provided useful insights into underlying inflation given

the unique shifts in demand and supply and the resulting price movements caused

by the pandemic. For example, CPI-common initially fell, reflecting the large amount

of excess capacity in the economy. However, CPI-median and CPI-trim filtered out

most of the weakness in inflation in some hard-to-distance service sectors. As supply

disruptions became prevalent in 2021, CPI-trim and CPI-median increased, reflecting

the inflationary pressures from components experiencing supply constraints.

Consequently, the range between the three measures widened further—highlighting

the value of looking at more than one measure of underlying inflation.

An updated evaluation of the statistical properties of the core measures confirms

that no single measure dominates—each has strengths and limitations (Table 1-A).

Still, the three measures are more useful than others because they effectively capture

persistent movements in inflation and they tend to move with the macroeconomic

variables that monetary policy affects. The current measures also remain less biased

and less volatile than other measures.

While the core measures have helped guide monetary policy, core inflation is just

one of many inputs in the process. It is important to consider the three measures

together with a detailed analysis of the determinants of inflation and broader

measures of capacity pressures. These measures include, but are not limited to,

labour market indicators, wages and other input costs such as commodity prices,

estimates of the output gap, and business and consumer survey results.

Table 1-A: Summary of an evaluation of different core inflation measures

CPI-common

CPI-median

CPI-trim

Unbiased

✔

Persistent



✔

Volatile



✔

Moves with output gap

✔

Looks through sector-specific shocks

✔

Has an easily understood methodology

✘

✔

 Top performance

✔

Favourable performance

Neutral performance

✘

Unfavourable performance

5 See Bank of Canada (2021a) for a discussion of the movements in core inflation measures during the pandemic.

6 For details, see Lao and Steyn (2019).

Monetary Policy Framework Renewal | 2021 | Page 11

The current review of the inflation-control target builds on the work done in

previous renewal cycles.

Inflation targeting has not only consistently delivered low and stable inflation

but also enhanced the resilience of the economy to external shocks, thereby

reducing volatility and improving overall economic performance.

For

example, real economic growth has been much steadier than it was before

the adoption of inflation targeting (as shown by a declining standard

deviation in Table 1). Nominal interest rates have also been lower and more

stable. This is mainly because inflation expectations have declined, but also

because the premiums to compensate investors for inflation risk have, on

average, been smaller.

Overall, the stability in inflation over the past 30 years has increased the

credibility of monetary policy and led to well-anchored inflation expectations.

7 The inflation-targeting regime has contributed to Canada’s improved economic performance for the past 30 years.

It has allowed Canadian businesses and households to read price signals more clearly, to respond to relative price

shocks more promptly and generally to allocate resources more efficiently. Canada’s flexible exchange rate has

complemented the monetary policy framework, facilitating economic adjustment to various internal and external

shocks. Many other factors have also helped improve Canada’s economic performance; these include the

entrenchment of sound fiscal policy, rigorous prudential regulation and supervision, and structural reforms.

Table 1: Canada’s economic performance before and after inflation targeting

Average (percent)

Standard deviation

October 2016 to

October 2021

October 2016 to

October 2021

Jan 1975

to Jan 1991

Feb 1991

to Sept 2016

Oct 2016 to

Dec 2019

Oct 2016 to

Oct 2021

Jan 1975

to Jan 1991

Feb 1991

to Sept 2016

Oct 2016 to

Dec 2019

Oct 2016 to

Oct 2021

CPI: 12-month increase

7.1

1.9

2.9

1.1

0.4

1.0

Real GDP growth*

2.8

2.4

2.5

2.2

3.8

2.6

1.3

13.2

Unemployment rate†

8.9

8.0

6.1

7.0

1.7

1.5

0.4

1.9

3-month interest rate‡

10.8

3.5

1.6

1.2

3.0

2.2

0.4

0.7

10-year interest rate§

10.7

4.9

1.9

1.5

2.0

2.2

0.4

0.6

Months in inflation-

control range (percent)

0.0 72.7 100.0 72.1

* This is the annualized quarter-over-quarter growth rate for quarters within the time period. The table incorporates real GDP data

through the third quarter of 2021.

† Unemployment data start in January 1976 with the introduction of a new labour force survey.

‡ The 3-month interest rate refers to the 3-month bankers’ acceptance rate.

Due to data availability before June 1982, the 10-year interest rate refers to the yield of government bonds with maturations

longer than 10 years; after June 1982, it is based on the 10-year government bond yield from Statistics Canada.

Sources: Statistics Canada, Investment Industry Regulatory Organization of Canada and Bank of Canada calculations

Monetary Policy Framework Renewal | 2021 | Page 12

Public perceptions of current inflation, however, are often higher than

measured inflation (Box 2). Nevertheless, the clarity and simplicity of the

inflation target enhanced the credibility and the general effectiveness of

monetary policy. Furthermore, the target made it easier for the public to hold

the Bank accountable for its performance. Through the years, the Bank has

sought to become more transparent in explaining its conduct of monetary

policy (see Box 10 in Chapter 6).

Box 2:

Differences between perceived and actual inflation

Survey data in several countries, including Canada, point to a gap between measured

and perceived inflation. This could raise concerns that the consumer price index (CPI)

does not accurately reflect inflation as experienced by many Canadians. Large

differences between perceived and actual inflation could eventually undermine the

legitimacy of the inflation-control framework.

The Bank of Canada held

consultations with Canadians

and studied possible

explanations for the

perception-measurement gap.

Responses to the Bank’s

Canadian Survey of Consumer

Expectations (CSCE) reveal the

gap between measures and

perceived inflation in Canada

(Gosselin and Khan 2015).

Households, on average, tend

to believe inflation is higher

than actual CPI inflation as

measured by Statistics Canada

(Chart 2-A). Still, current

perceptions of inflation have

been anchored firmly near the target. Consumer expectations of future inflation tend

to be above the target and vary more than perceptions of current inflation.

8 There is also evidence of some backward-looking expectations, as those who expect high inflation in the future

tend to perceive high inflation today.

-1

2015 2016 2017 2018 2019 2020 2021

Bank of Canada inflation-control target

Official CPI

Current perceptions of inflation

One-year-ahead inflation expectations

Chart 2-A: Households' perceptions of inflation tend

to be higher than official measures

Year-over-year percentage change, quarterly data

Last observation: 2021Q3

Sources: Statistics Canada, Bank of Canada and

Bank of Canada calculations

Monetary Policy Framework Renewal | 2021 | Page 13

Several factors can drive the perception-measurement gap (the difference between

the blue and green lines in Chart 2-A).

First, the CPI basket does not represent the spending habits of all individual

households. While the CPI measures the change in prices of goods and services

purchased by the average household, each household purchases different

proportions of the items in the CPI basket and experiences inflation somewhat

differently. In the Bank’s public consultations, participants said that in their view the

CPI does not effectively capture the rising costs of certain goods and services—for

example, the high cost of food in remote communities, education costs or the

growth in housing prices across the country. To assess the importance of these

differences, the Bank and Statistics Canada analyzed how the weights in the CPI

basket could be adjusted to better represent the spending patterns of different

demographic groups.

Results show that, on average, inflation rates based on

spending baskets for different cohorts are relatively similar to official CPI inflation.

A second factor driving the perception-measurement gap relates to the concept of

quality adjustment. Essentially, adjustments are made in the CPI to capture changes in

the quality of products as new models or varieties are introduced. But consumers often

do not recognize how much a product is improving over time and may focus on its

rising price rather than its higher value. This phenomenon is particularly important for

products with high rates of technological advancement. Without quality adjustments,

CPI inflation would be only about 0.2 percentage points higher on average, which

would explain just a small portion of the perception-measurement gap.

A third factor driving differences between perceived and actual inflation relates to

housing. Participants in public consultations highlighted the growth in house prices

as key to why they feel inflation is higher than 2 percent. Households usually

consider housing costs to be the acquisition cost. However, in the CPI, housing is

closer to a cost-of-living concept, measured as the imputed cost of services provided

by housing.

In recent years, the growth in house prices has tended to be much

greater than the increase in housing costs as measured by the CPI. This difference

can explain about 0.3 percentage points of the gap between actual and perceived

inflation.

Overall, the measurement issues reviewed seem to explain less than half of the

perception-measurement gap. Other behavioural factors might also be at play. For

instance, the loss of purchasing power as a result of significant price increases has

been found to have an outsized psychological impact. To test this, an alternative CPI

9 See Keshishbanoosy et al. (forthcoming).

10 The cost of housing includes all required expenses linked to living in and owning a house, including mortgage

interest costs, home-insurance premiums, maintenance and repairs, and replacement costs. See Sabourin and

Duguay (2015).

Monetary Policy Framework Renewal | 2021 | Page 14

inflation was calculated by trimming 20 percent of price declines and 10 percent of

price increases. Households’ expectations were found to be close to this alternative

measure of inflation, suggesting that consumers give more weight to price increases

and that excluding large declines could explain a significant part (0.7 percentage

points) of the gap between actual and perceived inflation.

An important explanation of Canadians’ elevated views of inflation could be

information gaps. When information about prices is not readily available or is too

costly to acquire, people rely on their own experiences to form expectations. Central

banks can help fill the information gaps by making information more readily

available and supporting economic literacy. Bank analysis shows that individuals

update their views on inflation when they receive new information, particularly

information about the Bank’s inflation target and about inflation forecasts.

Knowledge is also key: the inflation expectations of people with higher financial and

economic literacy are more in line with measured inflation. For instance, in the CSCE

results, the perception-measurement gap is largest for respondents with low levels of

education and income. In this context, new communication strategies to reach a

broader audience and increase financial and economic literacy are worth exploring.

The Bank’s The Economy, Plain and Simple series and the Bank of Canada Museum’s

education programs are steps in that direction.

Large external shocks over the years (such as the global financial crisis and the

COVID-19 pandemic) have led the Bank to use different tools within its

inflation-targeting framework. These have included, for example, forward

guidance and quantitative easing. However, inflation targeting as a framework

has endured, both in Canada and in many countries (Rose 2020). Although

economies faced different experiences during these shocks, no inflation-

targeting central bank moved away from having a clear inflation objective.

11 Perceptions of inflation also appear to be partly determined by a consumer’s own view of the costs of a small set

of products and services, which constantly increase; these include food prices, the cost of renting and house prices

(see Keshishbanoosy et al., forthcoming). However, while studies in other countries have found that recent

shopping experiences and frequent purchases such as gasoline and food may affect households’ overall inflation

expectations, Keshishbanoosy et al. calculate Canadian CPI inflation for frequent purchases and find little

difference over the past five years between the inflation rates of frequent purchases and that of the all-items CPI.

12 For details, see Kostyshyna and Petersen (forthcoming).

Monetary Policy Framework Renewal | 2021 | Page 15

Low inflation and maximum sustainable

employment

In essence, inflation targeting is about achieving low inflation together with

maximum employment because, to sustainably achieve either, the economy

needs both. Without maximum sustainable employment, the shortfall in jobs

and incomes will pull inflation below target. And without inflation near its

target and well-anchored inflation expectations, the economy would be less

resilient to various shocks, leading to large fluctuations in employment.

Since maximum employment is not directly observable, and in practice it is

hard to gauge when reached, a range of indicators should be examined to

assess the health of the labour market.

The most common measure of the state of the labour market is the

unemployment rate, which is defined as the percentage of the labour force

that does not have a job and is actively looking for work.

Before the

COVID-19 pandemic, the unemployment rate was close to a historic low due

to strong gains in full-time jobs in the service sector (Chart 2, panel a).

13 The labour force is the total number of employed and unemployed in the economy.

Chart 2: Before the pandemic, the unemployment rate was close to a historic

low and the employment rate was rising

Monthly data

Last observation: October 2021

Source: Statistics Canada

1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

a. Unemployment rate

1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

b. Employment rate

Monetary Policy Framework Renewal | 2021 | Page 16

A broader measure of labour market health is the employment rate, which is

the number of employed people as a share of the working-age population.

The maximum sustainable employment rate is determined largely by

structural factors beyond the control of monetary policy. For example, the

employment rate has risen over time (Chart 2, panel b). This is mostly due to

increases in the employment rate for women until the early 2000s. That said,

the inflation-targeting framework has contributed to reducing employment

fluctuations by stabilizing overall demand.

More recently, the pandemic had a large and uneven impact on the labour

market. The effects were more severe for certain sectors and their workers.

Hard-to-distance service industries—where physical distancing is either

difficult or impossible—suffered the most. Meanwhile, industries where

physical distancing or remote work is possible—such as professional services,

finance and public administration—were better able to adapt. These

differences across sectors led to unequal consequences. Low-wage workers,

women and young people were most affected.

Using flexibility

The Bank strives to make forward-looking policy decisions based on several

important considerations, drawing from a wide range of information. To

achieve this, the Bank has introduced a degree of flexibility into the practice

of monetary policy with an inflation target. At times this has led to the use of

different horizons to bring inflation back to target.

A key feature of the current policy framework is a risk management approach

that allows policy-makers to weigh multiple factors and risks during policy

deliberations. These include the risk of having the policy rate constrained by

the effective lower bound (ELB), other forecast risks, employment

considerations and financial stability concerns (Poloz 2020).

The Bank uses

a variety of models, data analysis, survey evidence and judgment to inform its

understanding of these factors and risks and how they might interact and

affect its ability to control inflation. The flexibility in the inflation-targeting

14 Kozicki and Vardy (2017) describe the uncertainties that central banks face. For instance, uncertainty is inherent

in measuring economic data and in unobserved metrics. Uncertainty is also linked to the models that are used to

inform policy decisions. And unforeseen developments are always possible.

Monetary Policy Framework Renewal | 2021 | Page 17

framework has allowed for adjustments in the expected time horizon for

bringing inflation back to target.

Other complementary policies could also help manage the trade-offs faced by

inflation-targeting central banks (Box 3). For example, automatic fiscal

stabilizers that increase spending during economic downturns can also help

monetary policy achieve the inflation objective and stabilize the economy

(MacKay and Reis 2016; Meh and Poloz 2018).

Box 3:

How monetary and fiscal policy can work together

Recent years have seen a revival of research into monetary and fiscal policies and

how they can reduce fluctuations in the business cycle and increase resilience to

external shocks. The 2008–09 global financial crisis showed that monetary policy

alone may be not be enough to lessen the negative effects of large shocks, especially

certain types. One implication is that the benefits of using both monetary and fiscal

policies to lean against big shocks may be greater than previously thought.

Monetary policy can generally react quickly to unanticipated changes in economic

conditions by changing the short-term interest rate, although its full impact on the

economy can take time. Changes to the short-term interest rate affect all firms and

households regardless of their exposure to a shock. Fiscal policy, in contrast, can

more easily target specific groups or sectors through transfer programs that are

quick to implement, which is helpful when shocks affect firms or individuals

differently. This has led some to argue in favour of a complementary approach,

where both monetary and fiscal policies are used to moderate the effects of shocks.

Fiscal policy can contribute to macroeconomic stability through three main policy

tools:

 Automatic fiscal stabilizers, such as employment insurance or progressive

personal income taxes, can help stabilize business-cycle fluctuations. They do this

by reducing swings in individuals’ disposable income and redistributing resources

from individuals with higher income to those with lower income. However, the

impact of some automatic stabilizers may be less because they can distort labour

15 See Bank of Canada, “Bank of Canada Releases Background Information on Renewal of the Inflation-Control

Target,” press release (November 9, 2011).

16 Dong et al. (2021) review the recent literature on the complementarities between fiscal policy and monetary

policy for stabilizing economic activity.

Monetary Policy Framework Renewal | 2021 | Page 18

market behaviour.

Because many automatic stabilizers have multiple policy

objectives, how best to design them is an open question.

 Changes to public spending and tax instruments can be designed to offset

business-cycle fluctuations by supporting aggregate demand. Some discretiona

iscal expenditures have short-term multipliers that are close to or above one

hich means that each additional dollar of expenditure translates into close to an

additional dollar of output. When interest rates are near the ELB, fiscal stimulus

s a larger impact. While discretionary spending can focus on the specific policy

priorities that are most relevant at the time, they may require legislation an

some ca

n take time to implement.

 Government credit programs extend credit to certain borrowers and

market segments and can implicitly or explicitly guarantee obligations of

government-sponsored enterprises. These credit policies can mitigate economi

downturns that are exacerbated by severe financial market distress.

The policy responses to the economic effects of the COVID-19 pandemic illustrate

how both fiscal and monetary authorities can respond rapidly to large shocks. The

responses to COVID-19 included unprecedented fiscal actions in some countries,

with large-scale programs introduced quickly to offset the sudden loss of income

that some households and firms experienced. While some fiscal policies were

targeted at the most affected households and firms, others were broader-based and

relied on existing transfer and tax systems—in some cases because new programs

take time to implement. Recent research examines the economic impact of various

elements of the fiscal response to the pandemic. For example, MacGee, Pugh and

See (2021) examine how the Canada Emergency Response Benefit (CERB) affected

household savings and debt, and Petit and Tedds (2020) highlight differences in how

Canadian provincial and territorial governments treated CERB payments in assessing

eligibility for income assistance programs.

During the pandemic, flexibility was exercised through an aggressive

monetary policy response. The Bank quickly reduced the policy rate to its ELB,

provided forward guidance and used additional tools such as quantitative

17 A variation suggested in the academic literature is a pre-committed fiscal spending formula that would be

triggered by certain macroeconomic conditions. Such a state-contingent, non-discretionary fiscal policy would

have the advantage of being timely and easy to communicate. But identifying appropriate and robust triggers and

sorting out how to develop credibility around the commitments could be challenging.

18 A growing literature examines programs introduced in other countries. For example, Autor et al. (2020) and

Chetty et al. (2020) examine the Paycheck Protection Program (part of the US Coronavirus Aid, Relief, and

Economic Security Act), while Romer (2021) asks whether aspects of the US fiscal response, such as one-time

stimulus payments, were well targeted.

Monetary Policy Framework Renewal | 2021 | Page 19

easing to support financial market functioning and reinforce the forward

guidance. The forward guidance demonstrated that even without room to cut

the policy rate further, the Bank can still provide monetary stimulus by making

a commitment to hold the policy rate at its ELB for longer than the degree of

excess capacity might suggest. Given the lags involved in the transmission of

monetary policy, the Bank’s response resulted in a projection for inflation that

temporarily exceeded 2 percent. Nevertheless, the public could be confident

that the Bank would remain focused on the inflation-control mandate even

while pursuing aggressive monetary policy to support a stronger, broader-

based recovery (see Box 8 in Chapter 5).

To maintain its credibility and enhance the public’s trust throughout the

pandemic, the Bank also committed to being transparent about the

parameters of its asset purchase programs and to reporting regularly on the

evolution of the its balance sheet. The Bank’s credibility and independence

were evident in market perceptions following Bank actions. For instance,

market expectations for policy rates generally tracked the Bank’s forward

guidance.

In addition, inflation expectations stabilized—allowing reductions

in the policy rate to be more fully passed through to real borrowing costs.

The results of the Bank’s consultations show that Canadians’ trust in the Bank

held firm or increased slightly during the pandemic and that people are highly

confident the Bank can continue to achieve its inflation target (Bank of

Canada 2021b).

19 The Bank’s commitment in July 2020 to leave the policy rate at the ELB was contingent on achieving the inflation

target on a sustainable basis. Following that announcement, market expectations for the policy rate flattened. In

October, the Bank reinforced its commitment and specified that it did not expect to sustainably meet the inflation

objective until some time in 2023. This updated forecast was credible because market pricing after the October

announcement had the policy rate at the ELB until at least 2023. As the outlook brightened in late 2020, market

pricing beyond 2022–23 moved slightly higher. But short-term yields remained anchored by the forward guidance.

In October 2021, the Bank’s projection was updated as the recovery progressed. The commitment to hold the

policy rate at the ELB until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved

was then revised to sometime in the middle quarters of 2022.

20 Professional forecasters’ long-term inflation expectations remain firmly anchored at 2 percent, while consumer

expectations in the Canadian Survey of Consumer Expectations and business expectations in the Business Outlook

Survey have bounced back relative to their 2020 levels. Market-based measures of expectations fell at the start of

the crisis, recovered as the Bank rolled out its quantitative easing program, and ticked up with the Bank’s decision

in July 2020 to commit to holding the policy rate steady until the inflation objective is sustainably achieved.

Monetary Policy Framework Renewal | 2021 | Page 20

Chapter 3: Key challenges for the

conduct of monetary policy

Over the past decade or so, several economic trends have accelerated,

affecting the Canadian economy. The 2008–09 global financial crisis and the

COVID-19 pandemic have had significant impacts on the global economy and

financial system. And forces such as demographic shifts, globalization, new

digital technologies and climate change are affecting the economic

landscape.

These economic and social trends raise two key challenges for the conduct of

monetary policy:

 The persistence of low interest rates since the global financial crisis has led

to a growing consensus that low neutral rates are likely to continue for

some time, constraining central banks’ ability to provide stimulus through

reductions in their policy rate.

 Major forces have increased uncertainty and made it harder to pin down

the maximum level of employment that the economy can sustain before

inflationary pressures build.

In addition, when conducting monetary policy, central banks need to consider

the historically high levels of debt held by households and businesses.

Despite significant advances in prudential financial regulations, particularly

with respect to housing finance, a prolonged period of low interest rates

could contribute to a buildup of financial vulnerabilities. Thus, while a number

of prudential, macroprudential and housing policy instruments are better

suited than monetary policy to address financial vulnerabilities, the possibility

that monetary policy could exacerbate these vulnerabilities remains an

important consideration.

A world of low neutral interest rates

The low interest rates observed in advanced economies since the global

financial crisis partly reflect low neutral rates, which many agree are likely to

persist in the coming years (e.g., Del Negro et al. 2019). This persistence

means central banks will have less room to lower their policy rates before

hitting the effective lower bound (ELB). As a result, ELB episodes are more

Monetary Policy Framework Renewal | 2021 | Page 21

likely to occur in the future than they were during the first two decades of

inflation targeting. Given the tendency for inflation to be below target during

ELB episodes, more frequent ELB episodes may make it difficult for the Bank

of Canada to achieve its inflation target of 2 percent.

To assess the likelihood of an ELB episode, we use the concept of the neutral

rate of interest. The neutral rate is defined as the policy rate that coincides

with output at potential and inflation equal to target after the effects of

cyclical shocks have dissipated. Although estimates vary across countries and

time periods, most agree that the neutral rate of interest has declined in

advanced economies since at least the early 2000s and is likely to remain near

its historical lows over the coming years.

In Canada, both the actual policy rate and the estimated neutral rate have

declined since the early 2000s (Chart 3). In the mid-2000s, the Bank assumed

a nominal neutral rate of roughly 5 percent. Since the global financial crisis,

estimates have shifted downward, and the 2021 Canadian nominal neutral

rate estimate is in the range of 1.75 to 2.75 percent, with a midpoint of

2.25 percent (Brouillette et al. 2021).

21 See, for example, Laubach and Williams (2003), Del Negro et al. (2019) and Feunou and Fontaine (forthcoming).

1991 1996 2001 2006 2011 2016 2021

Effective lower bound (+25 basis points) Policy rate Estimated neutral rate

Note: The grey range is the estimated range of the neutral rate, and the black line is the mid point of the range.

Source: Bank of Canada

Last observation: October 2021

Chart 3: The Bank of Canada policy rate and the estimated neutral rate

have declined

Monthly

Monetary Policy Framework Renewal | 2021 | Page 22

This decline in the neutral rate makes it more likely that monetary policy will

reach its ELB in future economic downturns. With a lower neutral rate, central

banks have less room to reduce the policy rate in response to negative shocks

before reaching the ELB. Staff estimate that the likelihood that adverse

economic shocks will result in the policy rate hitting its stated ELB of

0.25 percent has increased from 6 percent in 2016 to about 17 percent in

2021 (Chart 4, panel a).

The lower neutral rate has also extended the

projected average duration of ELB episodes from 2.3 quarters in 2016 to

about 7 quarters in 2021 (Chart 4, panel b).

The recent experience with the COVID-19 pandemic illustrates the

implications of ELB episodes for inflation (see Chapter 2). Even with a rapid

decrease of the policy rate to the ELB in response to weak aggregate demand,

inflation fell well below the 2 percent target. This is consistent with analysis

that ELB episodes often see inflation below target.

The risk of frequent and prolonged ELB episodes where inflation is

persistently below target has raised concerns that inflation, over the medium

term, may average below 2 percent. If inflation were to average below target

for a prolonged period, households and firms could adjust their inflation

expectations downward. This would cause the ELB to become even more of a

22 Staff used the Bank’s main dynamic stochastic general equilibrium model, the Terms-of-Trade Economic Model

(ToTEM) III, for this analysis. See Corrigan et al. (2021) for details on ToTEM III.

data

Chart 4: The probability of being constrained by the eﬀective lower bound on

the policy interest rate has increased

Note: In both panels, the 2021 real neutral rate is 0.25 percent, the 2016 real neutral rate is 1.25 percent and the real neutral rate before

the global financial crisis is 3 percent. Rates are calculated using the Bank of Canada’s Terms

-of-Trade Economic Model (ToTEM) III.

Source: Bank of Canada

2021 real neutral

rate

2016 real neutral

rate

Real neutral rate

before global

financial crisis

Quarters

b. Average duration of effective lower bound episodes

2021 real neutral

rate

2016 real neutral

rate

Real neutral rate

before global

financial crisis

a. Relative frequency of a binding effective

lower bound

Monetary Policy Framework Renewal | 2021 | Page 23

constraint because it would be more difficult to reduce the real policy rate. As

a result, central banks need to adjust how they conduct monetary policy.

Changes could include using a larger suite of monetary policy tools and

approaches more often. This would better mitigate the impacts of ELB

episodes on employment and output and help avoid inflation remaining

below 2 percent for extended periods of time (see Chapter 5).

Increased uncertainty about the level of maximum

sustainable employment

Major forces, including demographic changes, technological advancements,

globalization and shifts in the nature of work, have had profound effects on

the Canadian labour market. These evolving forces have increased uncertainty

around assessments of the level of maximum sustainable employment—the

highest level of employment that the economy can sustain before inflationary

pressures build. Added to this uncertainty is increasing evidence that the

relationship between economic slack and inflation is relatively weak as long as

inflation expectations remain firmly anchored.

As a result, inflation near

2 percent—by itself—is no longer a sufficient signal that the economy has

reached maximum sustainable employment.

The increased uncertainty about the level of maximum sustainable

employment poses a challenge to the conduct of monetary policy. When

deciding on monetary policy actions, the Bank looks ahead and adjusts the

degree of monetary stimulus to affect the level of total demand and help

close the output gap. Because inflation expectations are well anchored at

2 percent, inflation should return sustainably to target when slack is absorbed

and the economy is restored to maximum sustainable employment and its

productive capacity. However, with increased uncertainty regarding the level

of maximum sustainable employment, the risk of misjudging the appropriate

stance for monetary policy has increased.

Identifying the level of maximum sustainable employment has never been

easy. Indeed, many researchers have documented the wide confidence

intervals associated with estimates of the output gap or of the non-

23 Economic slack refers to resources in the economy that are not being fully utilized. These resources include

people who would like to work but are unable to find a job as well as machinery and equipment that are not being

used.

Monetary Policy Framework Renewal | 2021 | Page 24

accelerating inflation rate of unemployment (NAIRU)—a commonly used

measure of maximum sustainable employment. It should not be surprising

that identifying maximum sustainable employment is challenging because the

labour market itself is not one single market. It is, in fact, the sum of many

markets, differentiated by a variety of characteristics, including skill, industry

and location. Consequently, it is difficult to know whether everyone who

wants to be working is doing so, in a job that matches their skill set.

Ongoing structural changes in labour markets over the past few decades have

caused the level of maximum sustainable employment to change, making this

challenge even greater (Box 4). For example, an aging population and higher

levels of immigration have had an impact on the mix of workers’ skills. At the

same time, globalization and technological change—especially

digitalization—have affected labour demand. These still-evolving forces have

shifted the demand for and supply of different skill sets, and their net effect

on maximum sustainable employment is unclear.

Box 4:

Evolving uncertainties about the estimation of the

output gap and maximum sustainable employment

Economic research has documented the substantial uncertainties around the

measurement of unobservable variables, such as the output gap and maximum

sustainable employment.

These variables feature prominently in the

macroeconomic models that central banks use to predict when inflationary pressures

will emerge.

Structural changes in labour markets—driven by ongoing demographic shifts,

globalization and technological change, especially digitalization—have heightened

these uncertainties. These changes are affecting the demand for and supply of

different skill sets and possibly creating job mismatches. Since the 2008–09 global

financial crisis, employment rates (defined as the ratio of employed individuals to

24 Champagne, Poulin-Bellisle and Sekkel (2018) and Barnett, Kozicki and Petrinec (2009) show that the Bank of

Canada’s real-time estimates of the output gap are subject to large revisions. Similar results have been found for

other countries. For example, Orphanides and Van Norden (2002) show that real-time econometric estimates of

the output gap in the United States are subject to large revisions. Uncertainties around estimates of the non-

accelerating inflation rate of unemployment in Canada have been documented by Rose (1988) and Setterfield,

Gordon and Osberg (1992). Recent work by Brouillette et al. (2019) also finds that estimates of the trend

unemployment rate in Canada continue to come with large confidence intervals. These uncertainties around

estimates of maximum sustainable employment are also well established for other countries. For example, Staiger,

Stock and Watson (1997) report that it is not uncommon for the 95 percent confidence bands for the US NAIRU to

be roughly 3 percentage points.

Monetary Policy Framework Renewal | 2021 | Page 25

working-age population) for both men and women have remained below their pre-

recession levels (see Chapter 2). These lower employment rates are partly due to

long-term declines in the labour force participation rates of individuals aged 15 to

24, which are the result of increased school enrolment. However, these changes have

been accompanied by a rising prevalence of part-time or short-term work, especially

among young Canadians.

A related but distinct trend is the increase in “gig”

employment in which the worker is an independent contractor rather than an

employee.

While the net effects of these forces on maximum sustainable employment are

unclear, uncertainty about the level of maximum employment appears to be

particularly high after recessions. All of the decline in jobs involving routine work in

Canada occurred during recessions (Blit 2020), reinforcing the notion that firms

restructure their production processes during these times.

The share of long-term

unemployed workers rose in Canada during the global financial crisis (Kroft et al.

2019). A longer duration of joblessness not only increases the tendency for

unemployed individuals to leave the labour force but also reduces the likelihood that

non-participants will enter the labour force to search for jobs.

This suggests that

the trends in labour force participation and job polarization are intertwined. Areas

more severely hit by the global financial crisis in the United States observed a

persistent decline in their employment rates as workers chose to leave the labour

force (Yagan 2019), suggesting the possibility of labour market hysteresis.

The question of how to respond to increased uncertainty about the level of

maximum sustainable employment is further complicated by growing

evidence that the slope of the Phillips curve—the relationship between

inflation and economic slack for a given level of expected future inflation—is

flatter than previously thought. This means that inflation is less sensitive to

25 Morissette (2021) finds that since 1976, among youth aged 15–30 who are not in school, the proportion working

part-time as opposed to full-time jobs has increased substantially, and most of this increase has been involuntary.

26 More information about the gig economy can be found in Kostyshyna and Luu (2019) and Jeon, Liu and

Ostrovsky (2019). Also, for research on multiple-jobholding patterns, see Kostyshyna and Lalé (2019).

27 A growing line of research classifies jobs as routine or non-routine based on descriptions of the tasks required.

Jaimovich and Siu (2020) suggest that the hollowing out of routine jobs in the United States is concentrated

during recessions.

28 The unemployment rate is an imperfect measure of total slack (excess capacity in the form of potential workers)

in the labour market. For example, during a downturn, previously active job seekers may get discouraged and stop

looking for work, and people intending to enter the labour force may put off doing so. At such times, participation

in the labour market falls, and this can give misleading signals about how much employment really exists.

29 For a recent examination of the similarities between the Canadian and US labour markets, see Albouy et al.

(2019).

Monetary Policy Framework Renewal | 2021 | Page 26

changes in economic conditions. The evolving view of the relationship

between inflation and economic slack reflects not only the success of inflation

targeting in anchoring inflation expectations since the 1990s but also recent

research (Box 5).

Box 5:

Implications of a flat Phillips curve

The Phillips curve (PC) plays an important role in macroeconomic modelling in

academia and at central banks. Broadly speaking, the PC relates inflation to a

measure of economic slack, such as the output gap or the deviation of

the

unemployment rate from an estimate of its natural rate and expected future

inflation.

Although estimates of the PC can depend on model specification and sample period,

evidence is growing that the slope of the PC since the early 1990s has been relatively

flat (Landry and Sekkel, forthcoming).

A flatter slope of the PC means that large

fluctuations in the output gap are consistent with relatively stable inflation (Ball and

Mazumder 2011; Del Negro et al. 2020).

The flatness of the slope of the PC has important implications for how informative

inflation is about whether the economy is close to the maximum sustainable level of

employment (or potential output). In practice, inflation is measured imperfectly, and

transitory shocks (e.g., short-term supply disruptions) can temporarily affect the level

of inflation. With a flat PC and shocks to inflation, inflation can often be close to

2 percent even if the economy is below (or above) maximum sustainable

employment

or potential output.

30 See Kryvtsov and MacGee (2020) for a review of recent research on inflation dynamics and experience with

below-target inflation.

31 See Cacciatore, Matveev and Sekkel (forthcoming) for a more in-depth discussion.

32 The formulation of the PC has evolved together with macroeconomic thinking (see Gordon 2011). Beaudry and

Doyle (2000) estimate an accelerationist version of the PC for Canada and detect a decrease in the slope around

1990. Kichian (2001) estimates a time-varying parameter PC and finds similar evidence. Recent structural estimates

of the New Keynesian PC by Corrigan et al. (2021) also find a relatively flat PC for Canada. Recent innovative work

by Hazell et al. (2020) uses US regional data to identify the slope of the PC and concludes that the slope has been

flat since the 1980s. Furthermore, they argue that the sharp drop of inflation in the United States during the 1980s

was mostly due to shifting long-term inflation expectations. Similarly, Fitzgerald et al. (2020) use data from

metropolitan statistical areas in the United States from 1976 to 2010 and find a stable relationship between the

unemployment rate and inflation. Ongoing research explores the possibility of a convex PC—that is, the slope of

the PC increases the more the economy grows above potential. To date, the literature has not reached a clear

consensus on the convexity of the PC (Cacciatore, Matveev and Sekkel, forthcoming).

33 The estimated slope can depend on whether one uses a measure of core consumer price index (CPI) inflation or

total CPI. Although measures of core inflation are less volatile than total CPI and provide a better measure of

underlying inflationary pressures, they do not filter out all temporary shocks (see Box 1).

Monetary Policy Framework Renewal | 2021 | Page 27

An example that illustrates how a flatter PC could lead to current inflation being less

informative about maximum sustainable employment is shown in Chart 5-A. Building

from a two-equation model where inflation and potential output are both subject to

unobservable shocks, Cacciatore, Matveev and Sekkel (forthcoming) infer the

probability distribution for the output gap, conditional on inflation being at

2 percent.

Shaded areas in the chart represent the probability of the level of the

output gap (with 95 percent confidence). The two curves correspond to pre- and

post-1990s estimates of the slope of the PC reported by Hazell et al. (2020). With a

flatter slope (seen in the smaller value of the slope coefficient, κ), the distribution of

the output gap becomes much more dispersed. As a result, with inflation at

2 percent, a flatter slope means that confidence that the output gap is closed is

much lower.

A relatively flat Phillips curve poses a two-sided risk to monetary policy. On

one hand, it suggests that a more patient approach to tightening monetary

policy could have modest impacts on inflation in the near term. On the other

hand, it implies that if monetary policy is slow to respond to a sustained

34 Carter and Mendes (forthcoming) offer an alternative approach that allows the PC to take a nonlinear, convex

shape under which the curve steepens as the output gap becomes more positive. In this context, inflation

outcomes are relatively uninformative about the maximum sustainable level of output at low levels of output but

become more informative at higher levels of output.

Chart 5

-A: A flatter Phillips curve means inflation is less informative about the

output gap

Note: The two distributions of the output gap are derived using alternative values of the slope of the Phillips curve,

κ, taken from

Hazell et al. (2020). The pre

-1990s value is 0.0107 and the post-1990s value is 0.005.

-15 -10 -5 0

Output gap (percent)

0.0107

0.005

5 10 15

Monetary Policy Framework Renewal | 2021 | Page 28

buildup of inflationary pressures, bringing inflation back to its target may be

costly.

With a flatter Phillips curve, observing inflation near 2 percent is less likely to

imply that the economy is operating near maximum sustainable employment

(see Box 5). Given the uncertainty associated with ongoing structural changes

in labour markets, this suggests that it is now more difficult to know when

maximum sustainable employment is attained and the output gap is closed.

This raises the question of whether changes to the practice of monetary

policy could help the Bank better assess the maximum level of sustainable

employment consistent with the 2 percent target for inflation. For example, a

patient approach to applying monetary stimulus could help draw individuals

with limited attachment to the labour force into more productive employment

and help reduce persistent disparities in economic opportunity and income.

However, inflation expectations must remain well anchored for monetary

policy to succeed in keeping inflation on target.

Historically high levels of private debt

The historically high level of debt relative to gross domestic product (GDP)

among households and businesses remains an important consideration for

the conduct of monetary policy. Since 1990, household sector debt relative to

GDP has doubled and now exceeds 100 percent.

Although private, non-

financial business debt has grown more slowly since 1990, it also exceeds

100 percent of GDP.

With the expectation that interest rates will remain low

as a result of a low neutral rate of interest, the risk of a further buildup of debt

and associated financial vulnerabilities remains a concern (e.g., see the Bank’s

2021 Financial System Review).

Since the 2016 renewal of the monetary policy framework, the Bank has been

mindful of the risks associated with high levels of household or corporate

debt (Bank of Canada 2016). Elevated debt levels may create a difficult trade-

off between stabilizing inflation today and doing so tomorrow in the face of

35 Despite the doubling of household debt relative to GDP, the fraction of household income spent on debt

payments remains slightly below its 1990 level. While the rise in debt has led to higher principal payments, the fall

in nominal interest rates has lowered interest payments by more.

36 For a discussion of some of the challenges involved in measuring private, non-financial business debt, see

Duprey, Grieder and Hogg (2017).

Monetary Policy Framework Renewal | 2021 | Page 29

financial vulnerabilities or macroeconomic imbalances (Beaudry 2020a).

Monetary policy can mitigate some concerns about elevated financial

vulnerabilities by flexibly adjusting both the horizon for returning inflation to

target and the corresponding interest rate path (Bank of Canada 2011; 2016).

One tool to help quantify these potential trade-offs is the Bank’s recently

developed growth-at-risk framework (Adrian, Boyarchenko and Giannone

2019; Duprey and Ueberfeldt 2020; Boire, Duprey and Ueberfeldt 2021). While

the growth-at-risk framework offers important insight, research continues on

how best to model the intertemporal trade-off generated by elevated debt

levels and incorporate it into monetary policy decision making.

Research is continuing into the mix of policies that could best mitigate and

limit the buildup of financial vulnerabilities.

Based on the recent Canadian

experience, a variety of prudential, macroprudential and housing policy

instruments exist that are better suited than monetary policy to address these

vulnerabilities (Box 6). Further investments in strengthening Canada’s

macroprudential policy framework could also potentially increase the

effectiveness of these policies (International Monetary Fund 2019). Given the

importance of financial stability for good macroeconomic performance, this

issue will remain important for monetary policy.

37 The Bank discussed the possibility that some alternative paths for the policy rate could have similar implications

for inflation but different implications for the level of financial vulnerabilities. This illustrates that in some

situations no trade-off may exist between stabilizing inflation today and stabilizing it tomorrow in the face of

financial vulnerabilities. Monetary policy can also be a blunt and costly tool to target financial vulnerabilities,

especially compared with other tools such as macroprudential policies (Bank of Canada 2016).

38 The growth-at-risk concept provides a quantitative assessment of the trade-offs between different risks. In this

framework, choosing a rate path to minimize the departure of inflation from the target not only minimizes

macroeconomic risks to economic growth but also has consequences for financial stability risks to economic

growth. The framework still involves an element of judgment, as many of the relationships are estimated

imprecisely. Current research focuses on developing a framework that is more explicit about the mechanisms at

play—for example, exploring the formation of expectations, which can play a key role in the development of

financial vulnerabilities because departures from rational expectations can amplify boom-bust dynamics.

39 For a recent example, see Schroth (2021).

40 A related consideration is that high levels of debt may affect the transmission of monetary policy (e.g., Kaplan,

Moll and Violante 2018; Cloyne, Ferreira and Surico 2020). For example, Kartashova and Zhou (2020) examine how

Canadians with mortgages, which account for the majority of household debt, respond to changes in interest rates

when their mortgages come up for renewal. The authors find that changes in interest rates at renewal have an

asymmetric impact on consumer durable spending, deleveraging and defaults, with borrowers deleveraging if

rates rise at renewal. These asymmetric responses point to a risk that consumption could become more sensitive

to changes in interest rates.

Monetary Policy Framework Renewal | 2021 | Page 30

Box 6:

Macroprudential and monetary policy—Canadian

experience since the global financial crisis

For over a decade, the Bank of Canada has emphasized the evolution of household

financial vulnerabilities in its Financial System Review. Macroprudential policies have

adapted to address the vulnerabilities in Canadian housing and mortgage markets. In

particular, federal authorities—both the Department of Finance Canada and the

Office of the Superintendent of Financial Institutions (OSFI)—implemented and

expanded stress tests for insured and uninsured mortgages. These built on earlier

measures introduced between 2008 and 2012 to lower the riskiness of new mortgage

debt.

Following the global financial crisis, federal mortgage insurance qualification criteria

were tightened. Between 2008 and 2012, the maximum amortization of insured

mortgages was lowered from 40 to 25 years, and the loan-to-value (LTV) ratio limit

was reduced from 100 to 95 percent for a purchase and from 95 to 80 percent for

refinancing.

Overall, the rule tightening likely contributed to slower credit growth

after 2012 despite continued low interest rates (Chart 6-A).

The Bank’s policy rate remained constant between September 2010 and January

2015. In 2015, a sharp decline in oil prices prompted the Bank to cut its policy rate to

50 basis points. This reduction, along with continued downward pressure on long-

term yields in international markets, pushed five-year fixed-rate mortgages down to

then-record lows of 2.4 percent (Chart 6-A). This period of low mortgage rates also

saw a steady increase in the share of insured mortgage originations (with LTV ratios

above 80 percent) and uninsured mortgage originations (with LTV ratios less than

80 percent) with a loan-to-income (LTI) ratio over 450 percent.

41 For an overview of the Canadian mortgage market and related policy tools, see Ahnert, Bengui and Peterson

(forthcoming) and Kuncl (2016). In Canada, a refinance is defined as a mortgage origination where borrowers

either increase the amount borrowed (i.e., cash out) or extend the remaining amortization. In addition, some

mortgage renewals allow a borrower to switch lenders at the end of a mortgage term and sign a new contract

with a new interest rate and mortgage term. The ability to renew a mortgage is not affected by the rule changes

regarding refinancing.

Monetary Policy Framework Renewal | 2021 | Page 31

To counteract this growth of highly indebted households, the Department of Finance

Canada expanded the stress test for insured mortgages in 2016, while OSFI

expanded the stress test for uninsured mortgages in 2018.

These tightenings of

policy by federal authorities effectively increased by 200 basis points the rate used to

calculate the maximum debt service ratio to qualify for a mortgage. The result was a

sharp decline in the share of newly originated mortgages with an LTI ratio greater

than 450 percent.

Overall, the recent Canadian experience suggests that the macroprudential measures

on mortgages from 2008 to 2012, along with the expansion of stress tests in 2016,

have dampened credit growth resulting from lower policy rates. The stress test on

insured mortgages has worked to limit the growth of highly leveraged borrowers

(with a high LTI ratio and an LTV ratio at 95 percent). However, interest rates still

42 For more details on the expanded stress tests, see Bank of Canada (2018).

43 The OSFI stress test coincided with an increase in interest rates, which makes it difficult to separate the effects of

the stress test from those of higher mortgage rates (see Ahnert, Bengui and Peterson, forthcoming).

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Real estate secured lending (left scale) Policy rate (right scale)

Rule tightenings

Insured

mortgages

OSFI uninsured

mortgages

Note: OSFI refers to the Office of the Superintendent of Financial Institutions.

Source: Bank of Canada

Last observation: September 2021

Expanded stress tests

Chart 6

-A. Tightening macroprudential policy has contributed to slowing

credit growth despite lower policy rates

Monetary Policy Framework Renewal | 2021 | Page 32

appear to have a strong effect on the Canadian housing market and mortgage

originations.

The bottom line is that evidence suggests that macroprudential measures have

countered the buildup of financial vulnerabilities in Canada, lowering the likelihood

and severity of a shock affecting the entire financial system. However, household

debt remains elevated, and house prices have continued to increase rapidly. Thus,

the ability of macroprudential policy to prevent excessive risk taking during a period

of low interest rates may be incomplete. For this reason, monetary policy must be

mindful of its potential effects on financial vulnerabilities.

44 A related question is whether the buildup of financial vulnerabilities can contribute to future contractions in the

economy (as highlighted by Adrian, Boyarchenko and Giannone 2019). That is, can financial vulnerabilities create

macroeconomic risk independent of systemic financial risk? And if so, should macroeconomic stability be

considered a macroprudential policy objective in addition to that of managing systemic risk to the financial

system?

Monetary Policy Framework Renewal | 2021 | Page 33

Chapter 4: Lessons from a comparison

of alternative frameworks

As the 2021 renewal approached, important economic challenges—including

the lower neutral policy rate and uncertainty in the labour market—played

key roles in shaping a broad-based review of the Bank of Canada’s monetary

policy framework. The Bank thus conducted a “horse race” that consisted of a

side-by-side review of the main alternatives to inflation targeting.

This

review involved model simulations, lab experiments and public consultations.

In addition to the Bank’s existing flexible inflation-targeting (FIT) framework,

the comparison included:

 average inflation targeting (AIT)

 price-level targeting (PLT)

 an employment-inflation dual mandate

 nominal gross domestic product (NGDP)–level targeting

 NGDP-growth targeting

The Bank considered these frameworks because of their potential to address

the challenges discussed in Chapter 3. They are also the alternative

frameworks that have received the most attention in the economics literature

and in the broader discussion of monetary policy. Results from model

simulations, lab experiments and public consultations all factored into the

Bank’s evaluation of the frameworks against a range of qualitative and

quantitative criteria.

The analytical findings of the horse race align broadly with the results of

consultations with experts and the Canadian public. The current FIT

framework, AIT and a dual mandate were favoured over the other regimes,

which represented a larger departure from the status quo. In addition, while

neither AIT nor a dual mandate was judged to be better than FIT, the analysis

found value in some elements of each of these two alternatives.

45 In past renewals, the Bank considered specific modifications or alternatives to the existing framework, such as

changing the level of the inflation target or adopting price-level targeting.

Monetary Policy Framework Renewal | 2021 | Page 34

Key differences in the frameworks

The frameworks differ primarily in their degree of history dependence and

whether they include an explicit role for stabilization of a real variable.

Degree of history dependence

A framework is history-dependent if current policy relies on past outcomes,

even if those past outcomes are otherwise no longer relevant to how the

economy is evolving.

All else being equal, frameworks that involve a

commitment to make up for past deviations from some target variables

involve more history dependence than others. If individuals and private sector

businesses understand this commitment, it can shape their expectations and

behaviour. This influence on private sector expectations is particularly

beneficial when the policy rate is constrained by the effective lower bound

(ELB). Inflation is usually lower than the target during much of an ELB episode,

so it must subsequently “overshoot,” or be higher than, the target under a

history-dependent framework. This can help create expectations that the

policy rate will stay low for a longer period than would be required to return

inflation to target. Such expectations can stimulate demand even when the

policy rate is constrained by the ELB because they can affect long-term

borrowing rates, the exchange rate and asset prices. These results depend

critically on how the framework can condition the expectations of market

participants, businesses and the broader public.

In the horse race, the degree of history dependence embedded in the target

variables differs.

 Flexible inflation targeting: Monetary policy aims to achieve the inflation

target on a forward-looking basis, without reference to past deviations of

inflation from the target. The specification of the target variable does not

depend on history. In other words, bygones are bygones.

 Average inflation targeting: Monetary policy seeks to return a finite,

multi-year average of inflation to 2 percent. Since observations eventually

drop out of the averaging window and cease to be relevant, AIT has some

history dependence in the specification of the target variable.

46 See Woodford (2003) for a more detailed discussion of the definition and role of history dependence in

monetary policy.

Monetary Policy Framework Renewal | 2021 | Page 35

 Price-level targeting: Monetary policy seeks to make up for all past

deviations of inflation from its target to return the price level to a

predetermined target path that is consistent with 2 percent average

inflation. The average is calculated from a fixed date in the past, so the

averaging window grows over time. This approach carries a higher degree

of history dependence than AIT.

 Dual mandate: A dual mandate could be implemented by adding an

employment mandate to any of FIT, PLT or AIT, so the degree of history

dependence hinges on the price stability goal. In the Bank’s horse race, the

focus is on adding an employment objective to FIT, so no history

dependence is embedded in the target variables.

 NGDP-level targeting: Monetary policy seeks to maintain the level of

NGDP on a predetermined path that is consistent with a targeted average

nominal growth rate. As under PLT, this results in a high degree of history

dependence.

 NGDP-growth targeting: Monetary policy aims to stabilize NGDP growth

around a target rate. As under FIT, there is no history dependence in the

specification of the target variable.

In a wide range of macroeconomic models, the appropriate degree of history

dependence generally depends on the extent to which the private sector is

assumed to form its inflation expectations on a rational, forward-looking

basis. If private sector expectations are mostly rational and forward-looking,

then highly history-dependent frameworks such as PLT tend to perform best

due to their influence on inflation expectations. In contrast, if private sector

expectations are largely backward-looking, then history dependence can lead

to volatility in the real economy. Therefore, how these expectations are

modelled plays an important role in the evaluation of the alternative

frameworks.

Stabilization of a real economy variable

The frameworks also differ in terms of whether or not they include an explicit

role for stabilization of a real variable, such as output or employment, in

response to shocks.

 Flexible inflation targeting: The Bank’s current FIT framework does not

include an explicit objective to stabilize a real economy variable, but the

real economy’s performance is nonetheless a central consideration. Full

employment and output at potential are necessary conditions for

Monetary Policy Framework Renewal | 2021 | Page 36

achieving the inflation target on a sustained basis. In addition, the FIT

framework’s flexibility allows the Bank to consider implications for the real

economy when determining how quickly to return inflation to target.

 Average inflation targeting: Similar to FIT, AIT does not include an explicit

real economy objective, but achieving full employment and output at

potential are necessary for keeping average inflation sustainably on target

over a prescribed period.

 Price-level targeting: Similar to FIT, PLT does not include an explicit real

economy objective, but full employment and output at its potential are

necessary for keeping the price level sustainably on its target path.

 Dual mandate: With a distinct goal related to employment, a dual

mandate makes the stabilization of employment more explicit than under

FIT.

 NGDP-level or -growth targeting: NGDP-level and -growth targets

naturally include an explicit role for output or output growth stabilization

because NGDP is the product of the GDP price deflator and real GDP.

Results of the comparison

The Bank evaluated the frameworks using simulations in several different

economic models. The use of multiple models helps to isolate the key

mechanisms and assess the robustness of the main results. The Bank also

tested the frameworks in laboratory experiments in which participants were

asked to make decisions in the context of artificial economies. Finally, the

Bank’s extensive public consultations provided useful insights into Canadians’

views on the alternative monetary policy frameworks (Box 7).

Box 7:

Public consultations on monetary policy frameworks

In 2019–20, the Bank of Canada asked Canadians for their views about the current

inflation-targeting framework as well as several alternative frameworks. In an online

survey and focus groups, the Bank asked how well people thought each of the

frameworks could:

 achieve low and stable inflation

 provide a solid environment for growth and jobs

 support financial stability

Monetary Policy Framework Renewal | 2021 | Page 37

The Bank also asked how easy it would be to communicate each of the frameworks

to Canadians. More than 8,500 individuals completed the survey. Perceptions about

the difficulty in understanding each alternative framework were similar across all

demographic profiles, including age, gender, salary and education.

Low, stable inflation is most important to Canadians

Overall, over half of respondents (53 percent) said they would prefer to have stable

and predictable inflation so that they can better plan their lives. Only 27 percent said

steady economic growth was more important, while 20 percent said maximum

sustainable employment was more important.

Participants felt the groups most affected by inflation were people on fixed incomes,

the economically disadvantaged and seniors. Focus group participants frequently

mentioned growing inequality and disparities between “haves” and “have nots” as

issues they cared about. Many participants recognized and valued the important role

controlling inflation can play in mitigating inequality.

Views on monetary policy frameworks were diverse

In the consultations, Canadians expressed a variety of views on the different

monetary policy frameworks under review. Average inflation targeting was seen as

the easiest to understand of the alternatives to flexible inflation targeting (FIT), as

well as the easiest framework for the Bank to achieve. Participants said they prefer

that the Bank take longer to get back to the target with smoother adjustments in

interest rates over a longer period rather than moving quickly back to the target with

sharp and rapid interest rate changes.

Most of the survey respondents (80 percent) said a dual mandate was easy or

somewhat easy to understand. Almost 60 percent felt it would be difficult to achieve,

while almost 40 percent thought it would not be better than the current framework.

A dual mandate also elicited the most polarized responses. Many participants

suggested it could lead to the Bank becoming too politicized, and they questioned

how much of an impact monetary policy could ultimately have on employment.

About half of participants indicated they thought nominal gross domestic product

(NGDP)–growth targeting would not improve upon the Bank’s current framework.

NGDP-growth targeting was also least likely to be identified as the approach that

would best serve Canadians.

Overall, most people consulted supported the continued use of FIT as the Bank’s

approach to monetary policy. They recognized that a targeted range for inflation

works well for different economic situations and allows for a smoother adjustment in

interest rates over a longer time period. The majority viewed inflation targeting as

the most easily understood approach.

Monetary Policy Framework Renewal | 2021 | Page 38

Criteria

The Bank used a range of quantitative and qualitative criteria to evaluate the

alternative frameworks.

 Macroeconomic stability: Because the effects of monetary policy are

primarily macroeconomic in nature, much of the evaluation focused on

stability of prices and of the real economy (e.g., output and employment).

 Financial stability: A number of prudential, macroprudential and housing

policy instruments are better suited to address financial vulnerabilities, but

the monetary policy framework can also have implications for financial

stability.

 Distributional impact: The Bank sought to understand the distributional

implications of alternative frameworks. Structural factors tend to affect

long-term distributional trends, but the choice of monetary policy

framework can influence inequality during short-term fluctuations in the

economy.

 Robustness: A monetary policy framework must perform well in many

different circumstances. For this reason, the Bank evaluated the robustness

of frameworks to different economic shocks and behavioural assumptions.

 Understandability: Monetary policy works best when it is well understood.

The implications for communications and credibility are important, even if

difficult to measure. The public consultations and laboratory experiments

were essential for this part of the evaluation.

To perform well for all these criteria, a monetary policy framework must be

able to keep inflation expectations well anchored. The anchoring of inflation

expectations under FIT has allowed the Bank to react aggressively when

necessary and to take into account employment and other considerations

beyond inflation. Without well-anchored inflation expectations, monetary

policy would need to focus much more strictly on keeping inflation on

target.

47 Modern economic theory and empirical evidence indicate that inflation expectations are the main factor

influencing inflation. By keeping inflation expectations well anchored at target, monetary policy can maintain

inflation close to that target. Moreover, when inflation expectations are well anchored, movements in the policy

rate translate more directly into changes in the real interest rate, strengthening the effectiveness of monetary

policy.

Monetary Policy Framework Renewal | 2021 | Page 39

Analytical approaches

The Bank conducted most of the analysis of macroeconomic performance

using the Terms-of-Trade Economic Model (ToTEM), one of the Bank’s main

models of the Canadian economy (Corrigan et al. 2021).

Many of ToTEM’s

parameters are estimated to match the historical dynamics of the Canadian

economy. Notably, ToTEM’s structural equations assume that a significant

fraction of price- and wage-setters base their expectations on rules of thumb,

while the remainder act rationally. The importance of rule-of-thumb

behaviour undermines the performance of highly history-dependent

frameworks such as PLT and NGDP-level targeting. In contrast, FIT, AIT and

the dual mandate all perform relatively well in ToTEM (Dorich, Mendes and

Zhang 2021; Swarbrick and Zhang, forthcoming).

Given the central role private sector expectations play in how well history-

dependent frameworks perform, the Bank conducted additional analysis using

purpose-built models. Wagner, Schlanger and Zhang (forthcoming) compare

the performance of alternative frameworks in a model with bounded

rationality, or “cognitive discounting.”

They confirm the ToTEM results

regarding the underperformance of highly history-dependent frameworks.

Amano et al. (2020) study the optimal degree of history dependence under

AIT in a model where some firms have adaptive expectations. They find that

the best time frame for targeting average inflation is slightly less than two

years.

The Bank also conducted laboratory experiments to evaluate people’s ability

to forecast inflation and output under different frameworks (Kostyshyna,

Petersen and Yang, forthcoming). Actual inflation and output outcomes are

determined using a simple New Keynesian model, conditional on subjects’

median forecasts. Results suggest that FIT and the dual mandate are the most

stabilizing regimes, followed by AIT. Highly history-dependent policies

performed poorly.

ToTEM is not well suited for assessing the implications of alternative

frameworks for the distribution of income, wealth or consumption. For this

reason, the Bank used a heterogeneous agent New Keynesian model to assess

48 Technical details of the model-based evaluation of macroeconomic performance are broadly in line with those

described in sections 3 and 4 in Dorich, Mendes and Zhang (2021). See also Swarbrick and Zhang (forthcoming).

49 Cognitive discounting effectively decreases the weights that agents place on events further in the future when

making decisions today (Gabaix 2020).

Monetary Policy Framework Renewal | 2021 | Page 40

the distributional effects of these frameworks (Djeutem, Reza and Zhang,

forthcoming).

In the model, income inequality is linked to the output gap.

This captures the tendency for a rise in inequality to occur during recessions.

Djeutem, Reza and Zhang (forthcoming) find that highly history-dependent

frameworks cause inequality to vary more widely throughout the business

cycle.

Analyzing the financial stability implications of a monetary policy framework

continues to be challenging. Researchers at the Bank and elsewhere are

actively studying how to integrate financial vulnerabilities into

macroeconomic models, but no single, best model has yet been developed.

For this reason, the Bank relied on the existing literature to assess the financial

stability implications of alternative frameworks. In addition, Bank staff looked

at indicators from model simulations, such as the frequency and length of

periods with very low interest rates that could fuel risk-taking behaviours.

Comparing the performance of alternative frameworks with

flexible inflation targeting

Each of the alternative frameworks exhibits different strengths and

weaknesses. Table 2 summarizes the overall performance of these

frameworks relative to a FIT framework, based on the model simulations, lab

experiments and public consultations.

As shown in the table, no single

framework was found to dominate across all relevant criteria, though some

proved significantly more competitive than others. The performances of these

frameworks are presented here, beginning with the two that proved most

competitive relative to FIT—AIT and the dual mandate.

50 The model builds on Acharya and Dogra (2020) and Acharya, Challe and Dogra (2021).

51 The results of model simulations reflect the assumptions and structure of the model in question.

Monetary Policy Framework Renewal | 2021 | Page 41

Table 2:

Summary of the performance of alternative frameworks compared with flexible

inflation targeting

Average inflation

targeting

Dual mandate

Price-level targeting

NGDP-level targeting

NGDP-growth targeting

Price stability

Similar to FIT

Supports inflation

during ELB

episodes

Similar to FIT

Does not materially

change the

behaviour of

inflation

Superior to FIT

Stabilizes inflation

better

Keeps average

inflation at 2 percent

Provides certainty

about the long-run

price level

Slightly inferior to FIT

Does not directly aim to

stabilize prices, so

performance depends on

the evolution of trend

output

Relative-price shocks can

lead to volatility in

consumer prices even when

the GDP deflator is stable

Inferior to FIT

Substantially increases the

volatility of inflation, largely

because of poor

stabilization of the real

economy

Stability of

real economy

Similar to FIT

Supports activity

during ELB

episodes

Can lead to greater

volatility at other

times

Similar to FIT

Performs modestly

better on

employment

Modestly greater

volatility of the

output gap

Inferior to FIT

Leads to a substantial

increase in

unconditional

volatility of output

Supports activity

during ELB episodes

Slightly inferior to FIT

Leads to an increase in

unconditional volatility of

output

Supports activity during ELB

episodes

Inferior to FIT

Responding to growth rate

rather than level of real

activity leads to a very

substantial increase in

unconditional volatility of

output and employment

Financial

stability

Slightly inferior to

FIT

Increases low-for-

long tendency

Reduces scope for

discretionary

departures from

low for long

Similar to FIT

Does not materially

affect the

frequency of

episodes with

persistently low

interest rates

Inferior to FIT

Greatly increases

low-for-long

tendency

Reduces scope for

discretionary

departures from low

for long

Similar to FIT

Reduces tendency to cut

interest rates in response to

positive supply shocks

Reduces scope for

discretionary departures

from low for long

Similar to FIT

Reduces tendency to cut

interest rates in response to

positive supply shocks

Increases macroeconomic

volatility, which could

trigger financial risks

Distributional

implications

Similar to FIT

Similar volatility of

real economy leads

to similar cyclical

variation in

inequality

Similar to FIT

Similar volatility of

real economy leads

to similar cyclical

variation in

inequality

Inferior to FIT

Greater volatility of

real economy leads

to more cyclical

variation in inequality

Inferior to FIT

Greater volatility of real

economy leads to more

cyclical variation in

inequality

Inferior to FIT

Greater volatility of real

economy leads to more

cyclical variation in

inequality

Robustness

Similar to FIT

Somewhat greater

sensitivity to nature

of expectations

formation

More robust

performance in ELB

episodes

Similar to FIT

No material

change in

sensitivity to

assumptions and

shocks

Inferior to FIT

Much greater

sensitivity to nature

of expectations

formation

Inferior to FIT

Much greater sensitivity to

nature of expectations

formation

Inferior to FIT

Deterioration in

performance in many

situations, including

recoveries from recessions

Understand-

ability

Slightly inferior to

FIT

Multi-year average

of inflation is

understandable,

but less familiar

than year-over-

year inflation

Inferior to FIT

Having two

objectives reduces

clarity and

simplicity

Difficult to quantify

employment

objective

Inferior to FIT

Price level is an

unfamiliar concept to

many

Subjects in laboratory

experiments found it

difficult to forecast

Inferior to FIT

Nominal GDP is an

unfamiliar concept to many

Subjects in laboratory

experiments found it

difficult to forecast

Inferior to FIT

Nominal GDP is an

unfamiliar concept to many

Subjects in laboratory

experiments found it

difficult to forecast

Note: ELB is effective lower bound, FIT is flexible inflation targeting, and NGDP is nominal gross domestic product.

Monetary Policy Framework Renewal | 2021 | Page 42

Average inflation targeting

Under AIT, the target is a multi-year average of consumer price index

inflation. This report shows results for a three-year averaging period, but Bank

staff studied several other averaging period durations. To return inflation to

the multi-year average target, a period of below-target inflation must be

followed by a period of above-target inflation, and vice versa (Figure 1).

The model simulation results suggest that the main benefit of AIT is that its

embedded history dependence allows it to perform better than FIT at the ELB.

For example, in ToTEM, the average output gap during ELB episodes is

modestly narrower at -1.5 percent under AIT, compared with -1.7 percent

under FIT. Similarly, average inflation during ELB episodes improves from

0.8 percent in FIT to 0.9 percent in AIT. Thus, when the policy rate is as low as

it can go, AIT delivers slightly better outcomes for inflation and output.

The principal difficulty with AIT is that, when not at the ELB, it can lead to

volatility in the real economy. In particular, the need to follow periods of

above-target inflation with periods of below-target inflation means that

monetary policy would sometimes have to engineer a slowdown. In models

with fully rational expectations, a short period of weakness is usually enough

because price- and wage-setters anticipate the decline in future inflation and

moderate their respective price and wage increases. In more realistic models

Flexible inflation targeting Average inflation targeting Price-level targeting

Figure 1: History-dependent frameworks involve overshooting the

inflation target after a disinflationary shock and vice versa

0 1 2 3 4 5

time

b. Price level

Disinflationary

shock

0 1 2 3 4 5

(%)

time

a. Inflation

Disinflationary

shock

Monetary Policy Framework Renewal | 2021 | Page 43

like ToTEM, price- and wage-setters are not entirely rational, so a more severe

slowdown or recession may be needed to pull inflation down below target.

Employment–inflation dual mandate

A dual mandate has only a modest impact on employment outcomes

compared with FIT. Under FIT, the health of the labour market is central to

achieving the inflation target on a sustained basis. The model simulations

capture this through the important role that labour market developments play

in driving the output gap and wage growth.

In the Bank’s laboratory experiments, the dual mandate performed the same

as FIT and better than highly history-dependent alternatives such as PLT and

NGDP-level targeting. This suggests that subjects in the experiments had a

relatively good understanding of the dynamics under a dual mandate.

However, many participants in the Bank’s public consultations reported

finding the dual mandate somewhat more difficult to understand than FIT.

They also expressed concerns that a dual mandate could lead to higher

inflation and the politicization of monetary policy (see Box 7). These concerns

point to a risk that a dual mandate could detract from the clarity and

simplicity of the FIT framework—two features that have led to a strong

anchoring of inflation expectations. A de-anchoring of inflation expectations

could lead to excessive volatility in output and employment.

Price-level targeting

PLT is an extreme version of AIT. The price level reflects the entire history of

inflation, so targeting the price level is similar to targeting an infinite average

of inflation. This ensures that inflation averages 2 percent over time. The high

degree of history dependence means that PLT helps reduce the severity of

ELB episodes.

But, for the same reasons as under AIT, these gains come at the cost of

increased volatility in output and employment. The standard deviation of the

output gap rises from 1.3 percent under FIT to 1.5 percent under PLT. This, in

turn, implies more variation in inequality over the course of the business cycle.

In addition, subjects in the laboratory experiments found it difficult to forecast

in a PLT environment, and the heuristics they adopted led to destabilizing

dynamics. On balance, the costs of PLT appear to outweigh the benefits.

Monetary Policy Framework Renewal | 2021 | Page 44

NGDP-level targeting

NGDP-level targeting is modelled as stabilizing NGDP around a trend path.

This framework has received renewed attention because of its potential to

address some of the challenges of the current low interest rate environment

(see, e.g., Ambler 2020). Like PLT, the high degree of history dependence

inherent in NGDP-level targeting helps at the ELB but is destabilizing overall.

This framework’s macroeconomic performance is poorer than that of PLT

because of several unique characteristics:

 Monetary policy’s reactions to prices and output are forced to be equal

(because NGDP is the product of the GDP price deflator and real output).

This can result in inefficient responses to shocks.

 The framework implicitly reacts to output rather than the output gap,

meaning that shifts in potential output can lead to persistent deviations of

employment and output from their efficient levels. This can force

adjustment through inflation, leading to inefficient relative price

dispersion.

 Even when the framework stabilizes the GDP deflator, relative price shocks

can still lead to volatility in consumer prices.

Overall, compared with FIT, NGDP-level targeting raises the volatility of

inflation, the output gap and the policy rate.

A key practical advantage of NGDP-level targeting is that it avoids the need

to estimate the unobservable level of potential output or maximum

sustainable employment—monetary policy need only react to observed and

forecasted NGDP. This, however, must be weighed against the fact that NGDP

is measured imperfectly and revised over time. In addition, shifts in the trend

growth rate of potential output would further undermine this framework’s

performance relative to the simulation results, partly because these shifts

would exert persistent, growing impacts on the price level.

NGDP-level targeting also has implications for financial stability. By stabilizing

nominal income, central banks can help improve the risk-sharing properties of

non-contingent debt contracts, such as mortgages or vehicle loans, thereby

improving financial stability outcomes (Sheedy 2014; Bullard and DiCecio

2019). This framework also has advantages when dealing with positive

productivity shocks. Under NGDP-level targeting, the increase in output

counterbalances the incentive to ease monetary policy stemming from lower

prices. In contrast, under FIT, inflation and the output gap would both call for

Monetary Policy Framework Renewal | 2021 | Page 45

lower rates after a positive productivity shock, potentially increasing the

incentives for risk taking and debt accumulation. However, these benefits

must be set against the need to return nominal income to some target path.

This need can sometimes limit a central bank’s ability to depart from a low-

for-long policy even if the real economy has recovered and financial stability

concerns have become more prominent.

NGDP-growth targeting

Targeting the growth rate of NGDP leads to very poor macroeconomic

outcomes. This is due primarily to the performance of this framework in

recoveries. After a recession, growth can be strong even though the level of

output remains depressed. So, reacting to the growth rate of NGDP leads to

premature tightening of monetary policy, which would cut short a recovery

and stifle job growth.

Lessons from the horse race

Overall, the results of the horse race suggest that FIT, AIT and the dual

mandate are likely to perform better than PLT and both types of NGDP

targeting. This is consistent with the findings from the Bank’s public

consultations, where respondents viewed FIT, AIT and the dual mandate as

the most promising frameworks.

While these three frameworks all perform relatively well in several ways, none

dominates. Moreover, the differences in performance between these

frameworks are small, suggesting that any gains from a change in framework

would be modest. Nevertheless, two important lessons emerged from the

horse race.

Lesson 1: Nearly all the benefits of average inflation targeting are

at the effective lower bound

Under history-dependent frameworks like AIT, inflation is generally allowed to

rise temporarily above the target after an ELB episode. The anticipation of the

low-for-long policy rate required to generate this overshoot provides stimulus

when it is needed most during the ELB episode. However, when not at the

ELB, plausible departures from rational expectations, such as rule-of-thumb

strategies, can make history-dependent frameworks destabilizing.

Monetary Policy Framework Renewal | 2021 | Page 46

This raises the question of whether the benefits of history dependence could

be captured at the ELB without adopting a new framework. One approach

would be to use the type of state-contingent forward guidance analyzed by

Mendes and Murchison (2014). While AIT involves a commitment about the

path of inflation, a guidance-based approach would involve a commitment

about the path of the policy rate. Such guidance can be implemented in many

ways, so the details could be tailored to a given situation.

The Bank’s response to the COVID-19 crisis provides an example of this type

of guidance. The commitment to hold the policy rate at the ELB “until

economic slack is absorbed so that the 2 percent inflation target is sustainably

achieved” signalled the Bank’s intention to maintain monetary policy stimulus

longer than strictly required to achieve the inflation target. This approach uses

the flexibility of the FIT framework to provide additional stimulus without

committing to make up for past misses of the inflation target. Nevertheless,

communicating and exercising such “patience” would qualitatively mimic

some features of AIT. Analysis by Bank staff confirms that providing this type

of state-contingent guidance whenever the policy rate reaches the ELB can

deliver some of the key benefits of AIT (Chu and Zhang, forthcoming). This

approach keeps average inflation closer to 2 percent and improves inflation,

output and employment outcomes when the ELB is binding. Like AIT, this

approach would result more often in inflation rising temporarily above the

target after being below it for a period.

Lesson 2: A dual mandate only modestly affects employment

The economy’s performance under a dual mandate is similar to that under the

current FIT framework. Bank staff came to this conclusion using the standard

assumption that the levels of both potential output and maximum sustainable

employment are known to policy-makers. However, in reality, they are

unknown and inherently uncertain. As discussed in Chapter 3, major ongoing

structural changes to labour markets due to shifting demographics,

globalization and technological change accentuate this uncertainty.

Incorporating this uncertainty and the learning process of policy-makers into

the models used in the horse race is challenging. For this reason, Carter and

Mendes (forthcoming) develop a simple model that captures key aspects of

this learning process. One of their main findings is that the central bank tends

to learn more about the true levels of potential output and maximum

sustainable employment when the economy is operating above its productive

Monetary Policy Framework Renewal | 2021 | Page 47

capacity. This is because during these periods, the sensitivity of inflation to

economic activity tends to be relatively high, making inflation outcomes more

informative.

This finding suggests that allowing the economy to temporarily operate

above current estimates of its productive capacity can help policy-makers

learn about the appropriateness of those estimates. By doing this, monetary

policy is in effect probing for or seeking the maximum sustainable level of

employment. Carter and Mendes (forthcoming) show that policy frameworks

with this type of probing feature can yield some benefits. In particular, under

certain circumstances it can reduce the uncertainty surrounding the true levels

of potential output and maximum sustainable employment, which then

contributes to improved macroeconomic outcomes. However, these benefits

must be weighed against the costs. Probing may sometimes lead to inflation

temporarily rising above the target and could contribute to de-anchoring

inflation expectations.

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Chapter 5: Overview of monetary policy

tools

The Bank of Canada conducts monetary policy to achieve the objectives set

out in its inflation-control agreement with the Government of Canada and has

a number of monetary policy tools to do so.

The most commonly used is the policy rate, which influences the interest rates

that financial institutions use to set borrowing costs for households and

businesses. The Bank typically uses other tools only when the policy rate is at

the effective lower bound (ELB). Several of these other tools are outlined in

the Bank’s Framework for Conducting Monetary Policy at Low Interest Rates

(Bank of Canada 2015). They include extensions to how the Bank uses both

the policy rate and its balance sheet to affect other key borrowing rates in the

economy.

In Canada, the policy rate has fallen to the assessed ELB only twice, first

during the 2008–09 global financial crisis and more recently during the

COVID-19 pandemic (see Chapter 2). The Bank deployed additional tools

during the pandemic (Box 8), in some cases for the first time. While central

banks in several other jurisdictions have used a wider range of tools to

provide stimulus on various occasions in recent decades, Canadians may be

less familiar with some of these tools. But all of the Bank’s monetary policy

tools serve the same objective: to provide the appropriate degree of

monetary stimulus in order to achieve the Bank’s inflation target.

Box 8:

The Bank of Canada’s response to the COVID-19

pandemic

In normal times, the Bank of Canada delivers or withdraws stimulus as needed by

adjusting the policy rate. But the impact of the COVID-19 pandemic was

unprecedented, and it called for extraordinary action.

Monetary Policy Framework Renewal | 2021 | Page 49

The Bank took a range of swift and decisive actions to help mitigate the impact of

the pandemic on the Canadian financial system and economy. Specifically, the Bank

did this by:

 launching liquidity facilities and programs to support the functioning of financial

markets so that households, businesses and governments could continue to

access credit (most of these facilities and programs were discontinued as market

functioning improved)

 lowering the policy rate to 0.25 percent—the effective lower bound (ELB)—in

March 2020 and, beginning in July 2020, using forward guidance to communicate

that the policy rate would be maintained at the ELB until economic slack is

absorbed so that the 2 percent inflation target is sustainably achieved

 using quantitative easing (QE) to supplement and reinforce the reductions in the

policy rate and forward guidance by also helping keep longer-term borrowing

rates low

Re-establishing market functioning

The Bank’s first priority at the onset of the pandemic was to restore and maintain

smooth functioning of the financial markets essential to Canadians. When

widespread selling pressures caused liquidity to dry up sharply in multiple key

funding markets, the Bank rolled out several new facilities. These facilities were

effective in countering important strains and restoring well-functioning markets

(Fontaine et al. 2020; Gravelle 2021a).

For example, to bolster the capacity of commercial banks and other financial

institutions to support businesses’ short-term credit needs, the Bank launched a

facility to buy bankers’ acceptances. Spreads on bankers’ acceptances over

corresponding rates for overnight index swaps fell by 15 basis points on the day of

the announcement and by up to 70 basis points over a longer period (Arora et al.

2020).

Other programs to support short-term funding markets included the Commercial

Paper Purchase Program, which provided funding for a wide range of firms and

financial institutions, and the Provincial Money Market Purchase Program.

The Bank also targeted market functioning through the Provincial Bond Purchase

Program and Corporate Bond Purchase Program. These programs helped narrow

spreads that had widened considerably in March 2020. Both programs were relatively

small and were not considered a meaningful source of monetary stimulus. A year

52 For more details on the Bank’s actions during the pandemic, please see the Bank’s website.

53 The Bank’s purchases helped rebalance the lopsided trading flows in key debt markets, allowing buyers and

sellers to set prices. Also, because securities dealers have limited room for risk on their own balance sheets, the

Bank’s purchases helped free up dealers’ capacity to provide liquidity in these markets.

Monetary Policy Framework Renewal | 2021 | Page 50

after they were introduced, both programs were allowed to expire on schedule. Debt

markets had become fully functional again, with credit spreads for most borrowers

either at or below pre-pandemic levels.

The Bank also started making large-scale purchases of Government of Canada (GoC)

bonds in the secondary market through the Government of Canada Bond Purchase

Program (GBPP). When the program was first launched, the purchases mostly helped

improve liquidity, ensuring that the GoC bond market and, in turn, other debt

markets could work smoothly (Fontaine, Ford and Walton 2020). Once the program

was announced, yields on GoC bonds with less than three years to maturity fell by

about 15 basis points, with the yield curve about 10 basis points lower on average

(Arora et al. 2021).

Scaling stimulus to the shock as appropriate

Once market stresses dissipated, the focus of the GBPP shifted from restoring market

functioning to providing additional monetary policy stimulus—through quantitative

easing—and reinforcing the messaging of the Bank’s outcome-based forward

guidance.

The Bank also stopped buying short-term GoC bonds because yields on those bonds

were well anchored by forward guidance. Forward guidance and QE have been

complementary throughout the pandemic, with forward guidance keeping shorter-

term yields low and QE lowering yields of longer maturities.

By putting downward pressure on bond yields and lending rates throughout the

financial system, forward guidance and QE lowered borrowing costs for households,

businesses and governments.

Low borrowing costs and well-functioning financial markets helped businesses adjust

to the pandemic and supported household spending. This positive experience has

demonstrated that the Bank can use different monetary policy tools effectively to

help stimulate demand even once the policy rate is at the ELB, and to help return

inflation to the target sustainably. The Bank will continue to assess the impact of

different monetary tools used to meet its mandate.

As well, in a daily purchase operation, $1 billion of GoC bond purchases caused an average decline in yields of

about 0.8 basis points on purchased bonds—a decline of about 1.1 basis points in two-year and five-year

operations, i.e., the flow effect. For additional details, see Arora et al. (2021).

Monetary Policy Framework Renewal | 2021 | Page 51

Transmission channels

Adjustments to monetary policy reach different parts of the economy through

five main transmission channels.

 Interest rate channel: Monetary policy tools work through this channel by

affecting market interest rates and bond yields. It is sometimes called the

credit channel.

 Exchange rate channel: Changes to the level of interest rates or yields

relative to those of other countries can affect the exchange rate.

 Signalling channel: Through the signalling channel, a central bank can

influence expectations about future policy actions, thereby lowering

longer-term rates and reducing uncertainty. The signalling channel can

reinforce the interest rate channel.

 Liquidity channel: By purchasing financial assets, a central bank can make

it easier for buyers and sellers to carry out transactions in markets. This

helps ensure that the other transmission channels work as intended.

 Portfolio balance channel: By purchasing financial assets, central banks

can affect the quantity and mix of financial assets available to investors.

Changes to the available supply of assets, or to the amount of risk in the

financial system, can lead to a repricing of those assets.

The state of the economy and financial system affects the strength of each

channel and the impact of the policy tool being used (Figure 2). As well, the

effectiveness of each channel depends on economic conditions and on the

specific tool.

The size and structure of a country’s economy are also key factors. For

instance, in small open economies such as Canada, the exchange rate channel

tends to be more important than it is for economies with large internal

markets. At the same time, it also implies that interest rates further out the

yield curve are heavily influenced by the global forces.

55 The credit channel can also involve how monetary policy affects the quantity of credit available, rather than the

price.

Monetary Policy Framework Renewal | 2021 | Page 52

Monetary policy action

Risk-free interest rates of various maturities

Household and business borrowing rates

Aggregate demand

Output/labour gap

Inflation

Expected inflation

Exchange rates

Figure 2: The transmission channels of monetary policy

Monetary policy tools and how they work

When not constrained by the ELB, the Bank usually conducts monetary policy

by raising, lowering or maintaining the policy rate. At the ELB, the Bank may

deploy other tools to provide additional stimulus given that the policy rate

cannot be lowered any further. With ELB episodes now more likely (see the

discussion in Chapter 3 on lower neutral interest rates), other monetary policy

tools will need to be used more often.

Liquidity channel

Signalling channel

Interest rate channel

Portfolio balance

channel

Liquidity channel

Exchange rate

channel

Financial system

Monetary Policy Framework Renewal | 2021 | Page 53

Some of these tools are extensions of the Bank’s main approach to providing

stimulus—the policy rate—while others work through the explicit use of

central bank balance sheets.

Extensions of the policy rate

When the policy rate is at the ELB and further stimulus is needed to meet the

inflation objective, the Bank can go beyond its typical approach in two ways.

The Bank can either maintain the rate but help set expectations that it will

remain low for an extended period, or it can, on an exceptional basis, reduce

the policy rate into negative territory.

Forward guidance involves conditional statements or commitments about the

future path of policy rates. Central banks typically use these statements to

indicate that policy rates will be held at the ELB for a longer period than

historical patterns would suggest. Forward guidance can be purely calendar-

based—referring to a specific month or year—or outcome-based (also known

as state-contingent), often tied to the economic or inflation outlook.

Outcome-based forward guidance can also be connected to calendar-based

guidance through projections of when the economic outcomes are expected

to be achieved. Forward guidance therefore works primarily through the

signalling channel—affecting expectations and reducing uncertainty—and

provides additional stimulus by lowering relatively short-term yields.

Nominal policy rates can be negative, but there are limits. For example,

deposits will be converted to cash at some point. This is sometimes referred

to as the switch-to-cash rate.

Lowering the policy rate below the switch-to-

cash rate could impair financial markets, reducing the effectiveness of

monetary policy actions.

Balance sheet tools

Using balance sheet tools—a broad category of measures—the central bank

directly intervenes in financial markets to affect interest rates and borrowing

costs for consumers and businesses. In this sense, these tools have a similar

objective to that of the policy rate, but they may work through different

channels. The most common balance sheet tools used for providing

56 See the Bank’s guiding principles for central bank intervention for more information.

57 Witmer and Yang (2016), for example, estimate that the switch-to-cash rate in Canada has been -50 basis points

in the past. The switch-to-cash rate is a distinct concept from the reversal interest rate, which is the rate at which

accommodative monetary policy becomes contractionary for lending (Brunnermeier and Koby 2018).

Monetary Policy Framework Renewal | 2021 | Page 54

additional policy stimulus involve central banks’ buying financial assets,

usually sovereign government bonds. This increases the demand for the

assets, pushing up their price and putting downward pressure on their yields.

Because government bonds serve as the pricing benchmark for other debt,

lower yields on government bonds translate into reduced borrowing costs,

not just for governments but also for consumers and businesses.

Whether central banks are buying government or private sector debt, asset

purchases provide stimulus through three features:

 the flow of purchases

 the total expected stock of purchases

 the composition of purchases

Quantitative easing (QE) involves the central bank buying longer-term

government (or government-guaranteed) bonds. When conducting QE,

central banks announce a target level of purchases—either a total amount or

a pace (e.g., a target amount per week)—and the expected composition.

As noted, large regularly occurring government bond purchases provide

stimulus by putting downward pressure on government bond yields. This

helps lower borrowing costs across a range of securities through the interest

rate channel because yields on government bonds serve as benchmark rates

for other funding markets. When these markets are working well, QE works

similarly to changes in the policy rate, although QE’s main effects are on

longer-term interest rates. QE also works through the portfolio balance

channel because central bank purchases reduce the relative amount of

government bonds available for investors to buy. This causes them to

reallocate their holdings toward riskier debt. If these actions spur reallocation

across global portfolios, effects may occur through the exchange rate channel

as well.

During periods of financial stress, government bond purchases can also help

repair the liquidity channel, making it easier for buyers and sellers to conduct

transactions because the central bank acts as a price-insensitive buyer.

Increases in settlement balances (or central bank reserves) fund these

purchases. Settlement balances are interest-bearing central bank liabilities,

and when they increase as a result of QE, these increases are not permanent.

58 In some cases, central banks may also purchase sub-sovereign government debt as part of a QE program.

However, this is more typically aimed at restoring liquidity if these markets are impaired.

Monetary Policy Framework Renewal | 2021 | Page 55

This temporary feature clearly distinguishes QE from monetization of

government debt.

Yield curve targeting is similar to QE and works through the same channels,

but it focuses directly on the level of bond yields rather than on the quantity

of purchases. The central bank announces a target level for a specific yield,

typically at the middle of the yield curve, and stands ready to purchase

sufficient bonds to achieve that target level.

Credit easing involves purchases of non-government debt, such as corporate

bonds. These purchases reduce borrowing rates for those who rely on

market-based financing, which are typically priced at a spread over the yield

of a government bond of the same maturity. During a crisis period,

purchasing these bonds eases borrowing costs by repairing the liquidity

channel.

Credit easing can also provide stimulus through the portfolio balance and

exchange rate channels, similar to how QE provides stimulus through those

respective channels.

Collateralized lending provides financial institutions an opportunity to lock in

liquidity over the medium term, typically a one- to three-year horizon.

Examples include fixed-rate longer-term repurchase agreements (repos)

conducted at the policy rate. These programs help reinforce forward guidance

through the liquidity and signalling channels.

Funding for lending involves central bank provision of funding to commercial

banks at below-market rates, contingent on the banks increasing lending to

targeted borrowers. Typically aimed at small and medium-sized businesses

who rely heavily on bank financing, funding for lending programs work

primarily through the interest rate channel. Examples of such programs

include the targeted longer-term refinancing operations conducted by the

European Central Bank and the Bank of England’s Term Funding Scheme with

additional incentives for small or medium-sized businesses.

59 Beaudry (2020b) offers a more comprehensive description of the Bank’s QE program. An explainer entitled

“Understanding Quantitative Easing” is also available on the Bank’s website.

60 The Bank of Canada used term repos to reinforce its conditional commitment in April 2009, when it conducted

6- and 12-month term repos at the target rate.

Monetary Policy Framework Renewal | 2021 | Page 56

Effectiveness of monetary policy tools

Changes to the policy rate are acknowledged as the most effective and best

understood policy tool. The presence of an ELB, however, means that central

banks may need other tools when the policy rate cannot be lowered further

and additional monetary stimulus is needed. These tools are not perfect

substitutes for changes to the policy rate—their impact on economic activity

is less well understood. Nevertheless, evidence suggests that all of the

monetary policy tools discussed above can be effective in easing financial

conditions, which stimulates total demand and helps return inflation to target.

Monetary policy tools will be more effective if they are well understood—and,

as much as possible, accepted—by the public. Almost three-quarters of

respondents to a Bank consultation said they would not support the Bank

using negative interest rates (Bank of Canada 2021). Participants were more in

favour of the Bank using other tools: most indicated they support the Bank’s

QE program, and about two-thirds indicated support for forward guidance.

Johnson et al. (2020) provide an extensive literature review on which tools

work best and when.

Some key takeaways:

 Forward guidance commitments have proven to be effective at providing

additional easing by lowering shorter-term yields.

 Balance sheet tools such as QE and yield curve targeting appear to be

useful complements to forward guidance. All three mitigate negative

macroeconomic shocks by lowering medium- and longer-term yields.

 Credit easing and funding for lending are more targeted tools that have

been used effectively to restore market functioning in the financial system

and to increase access to credit.

 Central banks in some jurisdictions have provided additional monetary

stimulus by lowering policy rates into negative territory. Empirical

evidence, however, suggests that policy rate reductions become

progressively less stimulative—even when rates are still slightly above

zero—and may even reach a point where they become contractionary.

As noted above, the size and structure of an economy can affect how effective

each tool is in a given situation. In small open economies such as Canada, QE

affects both the level of domestic yields relative to global yields as well as

exchange rates. In addition, when faced with a global shock, small open

Monetary Policy Framework Renewal | 2021 | Page 57

economies may also be affected by the policy actions that their larger trading

partners take. For example, when the US Federal Reserve conducts QE, global

term premiums decline, resulting in lower term premiums on Government of

Canada bonds as well.

The health of the financial system matters. Certain tools have their greatest

impact when markets are impaired because part of what they do is improve

market functioning. But the structure of the financial system and relative

importance of different types of financial intermediaries also matter. For

example, purchases of private sector assets such as corporate bonds are more

likely to work better in jurisdictions where businesses tend to fund themselves

in markets and where financial assets are held as a source of wealth. Similarly,

jurisdictions that rely more on bank-based lending may benefit more from

programs such as funding for lending, which aim to stimulate demand by

giving banks incentive to make certain loans.

The role of other public financial institutions can be important for the

effectiveness of different tools while other non-monetary policy actions are

being taken. In Canada, Export Development Canada (EDC) and Business

Development Canada (BDC) are well-established Crown corporations that

provide funding to domestically based exporters and to small and medium-

sized businesses, respectively.

The federal government has used EDC and

BDC during crises to provide low-cost funding directly to businesses. So, the

impact of a funding for lending program in Canada could be much lower than

in countries that lack similar institutions.

In addition, some non-monetary policy actions can complement and reinforce

certain monetary policy tools, increasing overall effectiveness of economic

support policies.

For example, easing microprudential policies can facilitate

the portfolio balance channel of asset purchase programs (see Basel

Committee on Banking Supervision 2021).

Taking all of this context into account is important when assessing the tools’

ultimate impact. Moreover, multiple tools might be used at the same time,

61 Another key Canadian public financial institution is the Farm Credit Corporation, which provides financial services

to farms and other agricultural operations in Canada.

62 The effectiveness of other policies can also depend on monetary policy actions. For instance, simulations of

structural macroeconomic models suggest that fiscal multipliers are larger when monetary policy holds rates flat

at the ELB (De Resende, Lalonde and Snudden 2010). Miyamoto, Nguyen and Sergeyev (2018) and Ramey and

Zubairy (2018) provide supporting empirical evidence for Japan and the United States, respectively

Monetary Policy Framework Renewal | 2021 | Page 58

working through overlapping channels. So, the interactions among them must

also be considered when assessing the effectiveness of any one tool.

While academic discussion of balance sheet tools tends to focus on the size of

purchases and its impact on yields, looking at operational considerations is

also important. For instance, as asset purchases expand central banks’ balance

sheets, they also increase the central bank’s exposure to financial losses.

Appropriate policies governing the capacity for the central bank to absorb

financial losses, such as larger capital levels or financial reserves, are therefore

needed to support the credibility of asset purchase programs.

This provides

the central bank with a level of financial independence that helps support its

delegated operational independence to meet its inflation-targeting mandate.

And, to offset market functioning risks associated with a scarcity of some

assets in the market, securities lending and repo operations usually need to

be expanded to make the central bank’s asset holdings more readily available

to private investors.

Because monetary policy works to stimulate the economy by influencing

interest rates and asset prices, some analysts in Canada and elsewhere have

questioned whether some policy actions may also increase inequality.

Reductions in the level of interest rates and use of other monetary policy

tools can boost wealth by increasing the value of assets, such as the

investments that Canadians have in their registered retirement savings plans

or company pension plans. Given that these assets are not distributed evenly

across society, monetary policy can sometimes widen wealth inequality. Still,

by reducing cyclical swings in growth and employment, monetary policy

actions can help reduce income inequality, mainly by supporting a healthier

labour market that creates more jobs (Macklem 2012; 2021). The effects of

monetary policy actions on individual households can vary considerably,

though (Box 9). The Bank will continue to work to more fully understand the

impact of the policy rate as well as other monetary policy tools, such as QE,

on both income and wealth inequality in Canada.

63 See, for example, Stella (1997).

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Box 9:

Monetary policy and inequality

Before the 2008–09 global financial crisis, considerations related to inequality were

not at the forefront of the analysis of monetary policy. Distributional effects across

industries, income groups and occupations generally received less weight because

changes to the policy rate were seen as having broad effects on the whole economy.

Indeed, uneven effects that might have resulted from easing would typically be

reversed by the subsequent tightening.

In the years since the 2008–09 global financial crisis, though, there has been greater

emphasis on how monetary policy can affect inequality.

Countercyclical monetary

policy can help limit job losses and reduce the depth and duration of periods of

economic weakness. And, in doing so, monetary policy can reduce labour income

inequality to the extent that long periods of unemployment, especially for less-skilled

or low-wage workers, can have lasting effects on earning potential. Reaching

maximum sustainable employment is consistent with inflation targeting because

inflation can be kept on target sustainably only after excess capacity in the economy,

including in the labour market, has been absorbed.

Monetary policy’s impact on wealth inequality is more complicated. The long-

standing argument that monetary policy is neutral when evaluated over an entire

business cycle is harder to make when, as has been the case in many jurisdictions,

policy rates are kept close to their lower bound for several years. In addition, credit

easing—which has been used extensively as an ELB tool by central banks outside

Canada—is often perceived as tilted to benefit specific sectors.

Generally, monetary policy tools are blunt instruments that have broad effects.

Nevertheless, considering the transmission channels that policy tools work through is

important when evaluating potential differences in their effects on various segments

of the economy.

For instance, a change in interest rates has different effects on:

 savers versus borrowers

 those with existing debt versus those taking on new debt

 those with savings in assets such as housing, bonds and equities versus those

with savings accounts at banks and other financial institutions

This is true regardless of whether the change in interest rates is caused by a change

to the policy rate, forward guidance or balance sheet tools, although the latter may

64 In previous renewals, the Bank examined the redistributive effects of different levels of steady-state inflation

(Bank of Canada 2011) and those arising from a transition between steady-state inflation rates (Bank of Canada

2015). This analysis found that changes in inflation can have significant redistributive effects across different age,

income and wealth groups.

Monetary Policy Framework Renewal | 2021 | Page 60

have greater effects on targeted asset classes. In addition, whatever the tool, the

effects depend on the actual and perceived length of the change in interest rates—or

of asset purchases or other balance sheet or policy actions—and on whether savers

and borrowers face fixed or variable interest rates.

As well, some effects are almost instantaneous, while others are delayed. A large

proportion of consumer interest rates—for example, on mortgages, vehicle loans and

credit cards—are fixed. In these cases, it may take some time for existing borrowers

to see any benefit from a reduction in the policy rate, for instance. Similarly, the

nature of a savings product affects how much a saver benefits (or suffers) from a

change in the policy rate. Those with fixed-rate products could see little impact, while

those with variable-rate products or riskier assets may see more of an immediate

gain or loss.

The longer rates are expected to remain low, the larger the potential impact on the

prices of assets such as bonds, equities or housing. The impact on housing prices, in

particular, is often largely driven by the fact that demand for housing goes up

whenever borrowing costs go down. An initial outsized gain in house prices could

fuel expectations that such outsized gains will continue indefinitely, spurring investor

and speculative demand. But since more houses can be built, the impact on house

prices from low rates ultimately depends on how long the elevated demand lasts,

what is driving it and how long it takes to boost supply.

Monetary policy—through both changes to the policy rate and the use of balance

sheet tools—is therefore more likely to directly affect the wealth of those who

already have savings invested in bonds, equities and housing. While the easing and

tightening stages of the policy cycle may offset each other over time, the prolonged

period of low interest rates since the 2008–09 global financial crisis has led many to

see monetary policy as tilted toward asset holders and, as such, contributing to an

increase in wealth inequality. In contrast, the positive impact on jobs and income

inequality is less direct and can be harder to observe. This makes the overall impact

on individuals hard to determine given the differences in how Canadians accumulate

and manage their savings.

Monetary Policy Framework Renewal | 2021 | Page 61

Choosing tools and sequencing their use

The Bank applies tools in ways that are best suited to the nature of the

economic or financial shock. For example, academic literature and historical

experience suggest a baseline sequence for providing monetary stimulus to

respond to a negative shock to aggregate demand. Assuming that financial

markets are not impaired, a likely sequencing of policy would be the

following:

 Lower the policy rate, including to the ELB if economic and financial

conditions warrant it.

 Once at the ELB, use forward guidance to influence market expectations

and reduce uncertainty.

 Proceed with QE, if needed, to reinforce the forward guidance and provide

additional stimulus.

 Proceed with credit easing if further monetary policy stimulus is needed.

The larger the desired policy response, the quicker the central bank will

implement the different tools. For example, for a sufficiently large shock,

forward guidance and QE could be rolled out at the same time as the policy

rate is lowered to the ELB.

The baseline sequence above will not always be appropriate and therefore is

not predetermined. In any scenario where multiple monetary policy tools may

be needed, the context—including how a crisis evolves and any challenges to

the recovery—influences the sequencing. Assuming the policy rate is at the

ELB, and given that the effectiveness of any given tool depends on the

context, the Bank considers the following when deciding what to use and

when:

 the size, duration and nature of the shock

 the health of the Canadian and international financial systems

 the amount of additional monetary policy easing needed and existing

policy space for each tool

 how a tool would complement and interact with other monetary policy

tools as well as with other domestic and international policies

 implications for financial system vulnerabilities

65 Zhang et al. (2021) find that the policy mix that delivers the best outcome for the Canadian economy calls for

immediately implementing forward guidance and QE, followed by credit easing when containment measures are

lifted.

Monetary Policy Framework Renewal | 2021 | Page 62

 a communications strategy that provides different levels of detail for

different audiences and considers public acceptance of, and reputational

risk related to, the use of a given tool

 considerations around adjustments to programs once they have been

implemented

If the transmission channels are not functioning well, monetary policy will

have less or even no impact. Central banks can therefore use balance sheet

tools to improve market functioning and help restore the transmission

mechanism. When used for these purposes, pricing of these tools is

structured to serve in a backstop capacity—that is, they are only attractive to

market participants when markets are under stress. As conditions improve,

using them becomes relatively more expensive, so demand for them wanes.

However, when balance sheet tools are used explicitly to provide monetary

stimulus, programs are designed, scaled and calibrated to achieve the

monetary policy objective (i.e., the inflation target). Unlike backstop pricing

used for market functioning operations, the use of balance sheet tools for

monetary stimulus includes the explicit intention to influence market interest

rates. Central banks announce the size and composition of their intended

asset purchases, and transactions take place at prices determined in financial

markets. Decisions to adjust program details—such as expanding or reducing

a program’s size—are part of the monetary policy decision-making process.

Programs continue until the policy objective is achieved.

How tools interact with each other is important when considering how to

sequence them. As noted earlier, QE and yield curve targeting both

complement forward guidance, so the use and calibration of either can be

considered alongside forward guidance. For example, forward guidance and

QE can be combined to put downward pressure on yields across the curve

because each tool affects different maturities. In the case of yield curve

targeting, date-based forward guidance can be aligned with the term of the

yield that is being targeted. In contrast, pairing yield curve targeting with

outcome-based forward guidance poses communication challenges because

the targeted yield may arrive before the targeted economic outcome, or vice

versa.

Monetary Policy Framework Renewal | 2021 | Page 63

Normalization

Ultimately, monetary policy is countercyclical. Just as central banks add

stimulus when total demand is weak, less stimulus is needed as the economy

improves. This has been the approach to conducting monetary policy with the

policy rate. However, central banks have less experience with reducing or

unwinding the stimulus provided using balance sheet tools such as

quantitative easing.

When unwinding this stimulus, central banks need to take deliberate policy

actions that are guided by the economic outlook and monetary policy

objectives—particularly the inflation outlook—but in a way that also

maintains well-functioning markets. Economic and financial conditions and

the inflation outlook influence decisions about:

 when and how to slow the pace of purchases

 how long to maintain a stable amount of asset holdings

 when and how quickly to unwind the monetary stimulus

 the long-run level and composition of the balance sheet

The normalization phase is unlikely to follow the same path as the stimulus

phase. Normalization will likely be a more gradual process than adding

stimulus. As well, the policy tools used would not necessarily be unwound in

the reverse sequence of how they were implemented.

In general, as the economic outlook improves and less additional stimulus is

warranted, central banks will proceed in gradual and measured phases. One

likely sequence for a central bank that is using QE would start with

maintaining the policy rate at the ELB while gradually reducing the

incremental amount of its asset purchases.

As the recovery progresses, the central bank will eventually decide conditions

no longer warrant adding any additional stimulus through QE. Over this

period, it would purchase new bonds only with proceeds from maturing

bonds, thereby keeping the overall holdings of bonds on the balance sheet

constant. This is known as the reinvestment phase—it ensures that the

amount of stimulus remains the same over a period.

Once conditions warrant reducing the amount of monetary policy stimulus, a

central bank would likely begin by lifting its policy rate from the ELB.

A central bank would typically not lift the policy rate from the ELB while continuing to increase its asset holdings.

Monetary Policy Framework Renewal | 2021 | Page 64

To further reduce the stimulus in the system, the central bank could allow

maturing assets to roll off its balance sheet. Or, for a more aggressive

approach, it could actively shrink the balance sheet by selling the assets.

Bottom line

Central banks are increasingly using a broad range of policy tools to achieve

monetary policy objectives and will likely have to continue to do so because

of the low global neutral interest rate environment.

Choosing the appropriate tools and determining the sequence of their use

requires careful consideration. In particular, central banks will need to assess

the context, including:

• the nature of the shocks that they are responding to

• how well the various monetary policy transmission channels are

working

• what synergies among tools would be most effective in a given set of

circumstances

Fundamentally, though, monetary policy is intended to be countercyclical. As

the economy improves, less monetary stimulus will be needed to meet the

inflation objective. Just as with the initiation of various tools, actions to

unwind these tools will be guided by the economic outlook in order to

achieve the inflation target.

Monetary Policy Framework Renewal | 2021 | Page 65

Chapter 6: Strengthening the conduct

of monetary policy

Since 1991, monetary policy has operated within a flexible inflation-targeting

(FIT) framework. Over the past 30 years, both the framework and the

implementation of monetary policy have evolved to respond to structural

changes in the global and Canadian economies and to the evolution of

economic thinking. The flexibility inherent in the framework has allowed for

this evolution while keeping inflation low and stable and maintaining well-

anchored inflation expectations. In addition, monetary policy has made an

important contribution to the overall resilience of the Canadian economy.

Both the 2008–09 global financial crisis and the COVID-19 pandemic had a

significant impact on the global economy and financial system. And major

trends such as shifting demographics, new digital technologies and climate

change are altering the economic landscape. As discussed in Chapter 3, two

developments are particularly relevant to the conduct of monetary policy:

 Neutral interest rates are lower than in the past and are likely to remain

low. Consequently, central banks will have less room to lower the policy

rate in the face of big negative shocks to the economy. As a result, they

will need to use other monetary policy tools more often. Otherwise,

prolonged periods with the policy rate at the effective lower bound (ELB)

could result in inflation remaining below 2 percent.

 Shifting demographics, technological change, globalization and shifts in

the nature of work have had profound effects on the Canadian labour

market. These forces have made it harder to gauge the level of maximum

sustainable employment, which is the highest level of employment that

the economy can sustain before inflationary pressures build. In addition,

there is an observed weakness in the relationship between economic slack

and inflation, which has become more evident as inflation expectations

have become more firmly anchored.

Addressing these two challenges requires increased clarity in how the Bank of

Canada conducts monetary policy within the FIT framework.

Monetary Policy Framework Renewal | 2021 | Page 66

Targeting 2 percent inflation

Canada’s monetary policy framework will continue to target 2 percent

inflation—as measured by the 12-month rate of change in the consumer price

index—within the 1 to 3 percent control range. The analysis conducted as part

of this review reinforces that low and stable inflation remains the appropriate

target for monetary policy. The historical success in keeping inflation low and

stable provides valuable credibility, which helps to anchor medium-term

inflation expectations. In addition, as public consultations demonstrated, FIT is

straightforward to communicate and easy to understand compared with

alternative monetary policy frameworks.

This review included a broad range of analysis and research as well as

consultations with other central banks, the economics community,

stakeholder groups and the public. Although the Bank’s horse race (see

Chapter 4) and consultations compared alternative monetary policy

frameworks from different perspectives, both concluded that FIT remains the

best framework across a range of criteria.

Feedback from the consultations demonstrated that Canadians value low and

stable inflation and that, of all the frameworks, they understand FIT the best.

Many Canadians said they want the Bank to contribute to making the

economy more inclusive, but they recognize that several non-monetary forces

affect employment and economic inclusion and that monetary policy can play

only a supporting role.

Building on the success of FIT by incorporating the potential benefits of other

frameworks in certain circumstances, the Bank will continue to leverage the

flexibility of the 1 to 3 percent inflation-control range. The goal remains to

manage the trade-off between current and future risks to the inflation target

effectively and to return inflation sustainably to target within a reasonable

time frame.

Using the flexibility of the inflation-control range and

other tools

The Bank will continue to make use of the flexibility of the 1 to 3 percent

inflation-control range, along with a broader set of tools, to help address the

challenges of structurally low interest rates. Given low global interest rates,

the policy rate will likely hit its ELB more often, and, in response, the Bank may

Monetary Policy Framework Renewal | 2021 | Page 67

hold the policy rate at the ELB for an extended period. The Bank can be

patient—holding rates low for longer after an ELB episode—if it assesses that

this will help return inflation sustainably to target within a reasonable time

frame.

During ELB episodes, the Bank will also need to use a broader range of

monetary policy tools more regularly to support demand and employment

and to achieve the inflation target. These include forward guidance and

balance sheet tools such as large-scale asset purchases (quantitative easing

and credit easing).

While experience using these tools is limited, the

evidence indicates that they effectively provide additional stimulus. However,

they are not perfect substitutes for lowering the policy rate. Thus, the ELB still

represents a constraint to providing sufficient monetary stimulus when

needed.

Chapter 4 notes that patience at the ELB combined with state-contingent

forward guidance can provide similar benefits to frameworks that depend on

history, such as average inflation targeting, without committing to making up

for past misses of the inflation target. At the ELB, the Bank’s policy rate cannot

be lowered further to stimulate additional demand. However, since many

loans (e.g., vehicle loans and mortgages) are based on long-term rates, the

Bank’s commitment to holding the policy rate low for a prolonged period can

lower the rates at which consumers and firms borrow. This can stimulate

demand and help support a quicker recovery in employment and output.

By design, a low-for-longer policy rate increases the likelihood that inflation

could modestly and temporarily overshoot the 2 percent midpoint of the

inflation-control range as the economy recovers. A commitment to holding

rates low for longer means that monetary policy will likely begin tightening

only after inflationary pressures begin to build. The benefit is that the

additional stimulus can shorten the period during which inflation remains

below target. Thus, this policy can help keep inflation and inflation

expectations close to 2 percent.

While patience—implemented through forward guidance—is a core element

of the response during an ELB episode, the use of other monetary policy tools

may be appropriate in some circumstances. To support the effective use of

67 In rare circumstances, the Bank may also use yield curve control, funding for lending and negative interest rates

(see Chapter 5).

Monetary Policy Framework Renewal | 2021 | Page 68

these tools, the Bank will work with the Department of Finance Canada to

establish a framework that gives the Bank sufficient financial capacity to

manage its balance sheet to support the economy after adverse shocks and

achieve the inflation target.

Seeking maximum sustainable employment

When circumstances warrant, the Bank will refrain from raising rates pre-

emptively as inflation is approaching the 2 percent target. This will help the

Bank better assess the current level of maximum sustainable employment.

Reaching maximum sustainable employment is necessary for inflation to

remain on target, and achieving the inflation target is needed to sustain

maximum employment. The Bank will consider a broad set of labour market

and inflation indicators to guide its actions. It will not set a fixed target for

maximum sustainable employment because the precise level is unknown and

evolves over time.

Central banks have long recognized that the level of maximum sustainable

employment is unknown and time varying.

As discussed in Chapter 3,

ongoing structural changes to labour markets as a result of non-monetary

factors, such as globalization and digitalization, have accentuated this

uncertainty. Given the relative flatness of the Phillips curve, inflation is now

less likely to provide a clear signal when employment falls short of its

maximum level. As a result, when it is beneficial to do so, the Bank may

choose to actively seek, and continuously update its estimates of, maximum

sustainable employment.

To seek maximum employment, the Bank may sometimes tighten its

monetary policy stance more gradually than it would have in the past when

inflation is near the 2 percent target and employment is near the Bank’s

current estimate of the maximum sustainable level. Such a policy is often

referred to as probing, and it can allow employment to rise above the Bank’s

current estimate of its maximum sustainable level as long as inflation remains

near the midpoint of the inflation-control range and the Bank does not see

clear evidence of rapidly building inflationary pressures.

68 One reason many central banks—even those with a dual mandate—do not have a numerical target for

employment is because accurately identifying the level of maximum sustainable employment is impossible. This

level is largely determined by non-monetary factors that affect the structure of labour markets and cause

fluctuations in employment. As a result, the level may vary over time in response to changing economic forces.

Monetary Policy Framework Renewal | 2021 | Page 69

With probing, inflation might temporarily rise above the 2 percent target if

the level of maximum employment has not increased. This risk is offset by the

value of learning when the current estimate of maximum employment is too

low. Probing will also lower the likelihood of inflation remaining below

2 percent for extended periods.

Patience and probing will leverage the flexibility and credibility of the

framework to help manage uncertainty. The potential benefits of patience and

probing will need to be balanced against the risk that maximum sustainable

employment is lower than thought, which would lead to a larger overshoot in

inflation than projected. This cost-benefit calculation will depend on the

inflation context and economic conditions.

Maintaining well-anchored inflation expectations

Keeping medium-term inflation expectations anchored at 2 percent is

essential to maintaining the effectiveness of monetary policy. Combined with

low and stable inflation, well-anchored medium-term expectations help

provide Canadians with a stable environment in which to make long-term

saving and investment decisions. Moreover, when inflation expectations

remain well anchored, the framework has the flexibility to return inflation to

target over an appropriate time horizon. Since well-anchored inflation

expectations are critical to achieving both price stability and maximum

sustainable employment, the primary objective of monetary policy is to

maintain low, stable inflation over time.

Although patience and probing have distinct aims—to help manage the ELB

constraint and identify the maximum level of employment, respectively—they

are complementary. Both imply that inflation should sometimes be allowed to

temporarily and modestly overshoot the 2 percent target. By allowing such

overshoots, both practices would help offset the downward bias of inflation

associated with the ELB and keep inflation closer to 2 percent on average.

This, in turn, should help reduce the risk of de-anchoring inflation

expectations downward if ELB episodes become more frequent.

The use of the flexibility provided by the inflation-control range does not

imply that the Bank has adopted so-called makeup strategies that pursue a

period of above-target inflation after a period of below-target inflation. While

patience and probing may result in modest and temporary overshoots of the

inflation target, these overshoots may not happen if the productive capacity

Monetary Policy Framework Renewal | 2021 | Page 70

of the economy is larger than assumed. Thus, this approach to using the

flexibility of the inflation-control range differs from a policy of committing to

systematically pursuing above-target inflation for a prolonged period.

A patient approach of maintaining low rates when there is heightened

uncertainty over the level of maximum sustainable employment can help the

Bank achieve its inflation target; however, this approach poses

implementation challenges. If the Bank were to respond too late to a period

of accelerating inflation in the presence of a flat Phillips curve, the output cost

of reversing an increase in inflation expectations could be substantial. In

addition, if the Bank were to repeatedly respond too late to growing

inflationary pressures, inflation expectations could become de-anchored and

drift upward.

As part of its approach, the Bank will develop a dashboard that includes a

range of indicators of labour market performance.

The Bank will carefully

monitor, assess and refine these and other indicators of inflationary pressures

over the coming years.

Assessing financial vulnerabilities

The Bank will continue to assess financial system vulnerabilities, recognizing

that a low interest rate environment with high levels of debt can lead to

financial imbalances. A variety of microprudential, macroprudential and

housing policy tools are better suited to address these financial vulnerabilities

than monetary policy is. The recent experience with macroprudential policy in

Canada, particularly in housing finance, suggests that well-designed policy

tools can mitigate financial vulnerabilities and reduce systemic risk in the

financial system (see Chapter 3). The Bank will continue to work with the

Department of Finance Canada and other relevant regulatory agencies to

ensure that Canadian arrangements for financial regulation and supervision

remain fit for purpose.

69 The Bank remains mindful of lessons from history in the conduct of monetary policy, particularly the experience

of the Great Inflation from 1965 to 1982. Economists continue to debate the factors behind the sustained rise

in inflation in the 1970s, but they agree that central bank policy played a key role. This episode clearly

demonstrated that there is no long-run trade-off between lower unemployment rates and higher inflation (e.g.,

Bryan 2013). Another enduring insight is the importance of well-anchored inflation expectations, as shifting

expectations contributed to the Great Inflation and the subsequent cost of lowering inflation (e.g., Solow 1979).

70 Ens et al. (2021) outline a preliminary approach to a range of labour market indicators to help guide monetary

policy.

Monetary Policy Framework Renewal | 2021 | Page 71

Nevertheless, the Bank will remain mindful that monetary policy could

exacerbate financial vulnerabilities. Elevated financial vulnerabilities and

possible episodes of financial stress could eventually lead to worse economic

outcomes. This intertemporal trade-off poses a challenge for monetary policy

because it may make it harder to achieve the inflation target in the future.

The Bank has made important strides in incorporating issues related to

financial vulnerabilities into its discussion of monetary policy. It will continue

to refine and improve its understanding of these issues in line with the Bank’s

risk management approach to the conduct of monetary policy outlined in the

2016 renewal.

This approach aims to more effectively manage the trade-off

between risks to the inflation target now and those in the future.

Building capacity to assess the impact of climate

change

Climate change poses substantial risks to the global and Canadian economies.

While monetary policy cannot directly tackle the threats posed by climate

change, the Bank will take into account the important effects of climate

change on the Canadian economy and financial system and will work with

international and Canadian partners to mitigate climate-related financial risks.

To conduct monetary policy effectively, the Bank must understand the

potential impacts of climate change on the macroeconomy, inflation and jobs.

Climate change is also highly relevant to the Bank’s mandate to foster a stable

and efficient financial system. To address climate change consistent with its

mandate, the Bank will:

 advance the development of its modelling tools and conduct further

research to better understand and assess the macroeconomic implications

of climate change

 review its operational framework for monetary policy with a view to

including climate change considerations where appropriate

 assess the risks that climate change poses by supporting the identification

of risk exposures, promoting best practices in climate risk disclosure and

71 See Beaudry (2020a).

72 See Bank of Canada (2016).

Monetary Policy Framework Renewal | 2021 | Page 72

management for the financial sector, and enabling efficient pricing of

climate-related risks in the market

Enhancing communications

Monetary policy works best when it is well understood and the reasons

behind decisions are clearly explained. Through the years, the Bank has

sought to become more transparent in communicating its goals and

explaining its conduct of monetary policy (Box 10). With these important

changes to the implementation of monetary policy, the Bank will

communicate clearly when and why it is making use of the flexibility of the

1 to 3 percent inflation-control range.

Box 10:

Evolving communications, increased transparency

Over the past 30 years, central banks, including the Bank of Canada, have moved

from communicating very little about their policies and actions to progressively

increasing transparency (Poloz 2018). These efforts have enhanced the credibility and

effectiveness of monetary policy actions by guiding expectations, and they have

fostered greater accountability and public trust in the central bank.

The advent of inflation targeting in 1991 provided a clear objective for monetary

policy and gave the public a straightforward way to measure the performance of

their central bank over time. Since then, the Bank has implemented a series of

communications initiatives to:

 demonstrate its accountability

 explain its economic projections and policy decisions

 provide open access to staff research and data

 include insights from businesses, financial markets and consumers in the policy

process

Notable initial measures include:

 publishing the Bank’s forecasts for the economy and inflation in the Monetary

Policy Report (MPR)

 establishing regional offices to act as the Bank’s representatives with

stakeholders across the country

 appearing regularly before parliamentary committees to explain the Bank’s policy

decisions

 introducing eight fixed announcement dates for interest rate decisions,

accompanied by a press release explaining the decision

Monetary Policy Framework Renewal | 2021 | Page 73

 establishing a formal and regular monetary policy framework renewal process,

with a clear and public research agenda

Over the past three decades,

the number of speeches and

media activities by Governing

Council members has increased

significantly (Chart 11-A). These

speeches provide the public

with greater insight into the

Bank’s thinking on the

economy.

More recently, the Bank

expanded the content of the

opening statements for the

MPR and introduced speeches

presenting an economic

progress report after policy

decisions not accompanied by

an MPR. These changes provide greater insight into Governing Council’s policy

deliberations.

Input from businesses, financial markets and consumers has played a greater role in

the decision-making and communications process through the Business Outlook

Survey, the Senior Loan Officer Survey and, more recently, the Canadian Survey of

Consumer Expectations.

The Bank also now regularly publishes staff research and analysis that feed into the

policy-making and forecasting processes, including staff projections with a time lag.

In addition, where possible, the Bank provides open access to its data and models

(Wilkins 2015).

The Bank has also expanded the range of stakeholders it engages with, putting in

place a dedicated stakeholder relations function and strategy to guide its efforts

(Macklem 2020). Overall, the Bank has sought to better understand the information

needs of its various audiences. Accordingly, it has expanded its digital and social

media presence to offer content accessible to anyone interested in gaining a better

understanding of the economy and the Bank’s role.

When the COVID-19 pandemic struck, the Bank responded with unprecedented

policy actions. The Bank’s communications focused on helping Canadians

understand the new tools the Bank used, such as quantitative easing, and how they

contributed to supporting the economic recovery. The Bank placed a premium on

1935 1952 1969 1986 2003 2020

Source: Bank of Canada

Last observation: 2020

Chart 11-A: Bank of Canada public

speeches, 1935 to 2021

Speeches

Monetary Policy Framework Renewal | 2021 | Page 74

further enhancing the relatability of its communications and ensuring maximum

transparency by communicating proactively through multiple channels.

During an ELB episode, the Bank will likely use forward guidance on the

expected path of the policy rate. It will continue to be clear about the

rationale for the forward guidance it provides. In these cases, the anticipated

impact on inflation will be reflected within the Bank’s published forecasts.

A key input for determining the appropriate path for monetary policy is the

Bank’s assessment of the output gap. Employment is the most important

element in this assessment, but its importance has not been emphasized

consistently in past communications. Moving forward, the Bank will

systematically report to Canadians on the role played by labour market

outcomes in the assessment of the output gap and forecasts of inflation. This

will include more extensive reporting on a broad set of labour market

indicators and how they factor into its monetary policy decisions.

By helping to achieve maximum sustainable employment, monetary policy

contributes to a more inclusive economy that provides opportunities for

Canadians to participate in the labour market. However, monetary policy is a

broad macroeconomic instrument that cannot target specific segments of the

economy. As a result, monetary policy can play only a supporting role in

promoting better and more inclusive employment outcomes.

Providing increased clarity on the conduct of monetary policy helps build on

the Bank’s past success in achieving low and stable inflation and contributing

to overall macroeconomic stability. Leveraging the flexibility of the framework

addresses important structural changes in Canada’s economy and is intended

to maximize the shared benefits that monetary policy can deliver for

Canadians. The clarity and continuity of the renewed monetary policy

framework will continue to support the Bank’s primary objective of

maintaining low, stable inflation over time.

Monetary Policy Framework Renewal | 2021 | Page 75

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