Central banks will stay on the alert as they guide the recovery

The writer is governor of the Bank of Canada

Even as the global economy recovers, the pandemic continues to challenge people, businesses and governments. For central banks, charting and communicating monetary policy now requires a more delicate balance. In Canada, as in many other countries, we still need substantial monetary stimulus to recover fully, but inflation risks have increased with higher prices for many goods — driven by pandemic-induced demand shifts, supply disruptions and higher energy prices.

Despite the unprecedented nature of this crisis, we have remained guided by our framework, which is focused on a nominal inflation anchor. But in carrying out our policies, three lessons have become clear.

First, be bold on entry and plan for exit. While it takes courage to embark on exceptional policies, ending them is at least as hard. Faced with a sudden and acute crisis, it is imperative to overwhelm it and underpin confidence.

But to do that credibly, we need to have a plan to exit from the emergency response when the time comes. Like many central banks, we rolled out unprecedented liquidity and stimulus programmes at the beginning of the crisis, first to restore market functioning and then to support recovery. From the start, we did our best to define the conditions for our exit despite the enormous uncertainty.

For our asset-purchase programmes aimed at restoring market functioning, that definition facilitated a smooth exit once markets normalised. For our quantitative easing purchases, broad exit conditions anchored the gradual tapering that we began in April and completed with the shift to reinvestment in November. For the policy interest rate, our forward guidance has been clear that we will not raise interest rates until economic slack is absorbed. We are not there yet, but we are getting closer.

The second lesson we have learnt is that, when faced with a unique crisis, it is better to focus on outcomes than on timelines. When we began QE, we said it would be in place until the recovery was well under way, even if we did not know when that would be. Now that our economy has largely reopened, overall employment is back to pre-crisis levels and growth is forecast to be around 5 per cent in 2021, the recovery is clearly making good progress. Adding further stimulus through QE is no longer needed.

As for our forward guidance on the policy interest rate, we were clear from the outset that it was based on an outcome — that slack in the economy would need to be fully absorbed so that the 2 per cent inflation target is sustainably achieved. Our forecasts put that on a timeline, but of course forecasts change with new information. As that new information has come in, we have twice brought forward the likely timing of slack being absorbed, but our forward guidance has not changed. By focusing on outcomes, we have harnessed the power of our policy tools while being clear about the extreme uncertainty that has prevailed through this crisis.

That leads to the third lesson: be prepared for the unexpected and be humble. The world has never been through a crisis quite like this. We’ve never shut down the economy and tried to reopen it, multiple times. Our models never contemplated mandatory lockdowns, physical distancing or masks.

To manage the uncertainty, we used novel, real-time data sources to supplement traditional economic data. We have been forthright about our projections and the confidence bands around them. Even as the recovery has progressed faster than expected, every stage of the crisis has brought new surprises, reminding us to be humble. This humility is embedded in how we structure and use QE and forward guidance.

A focus on outcomes and a reliance on a solid policy framework means that while people can challenge our economic forecasts, they can still have confidence in our resolve to keep inflation under control and to support a full and inclusive recovery.

Let me be clear about what that resolve means. It does not mean we have changed our view that recent inflation dynamics are transitory. We continue to believe slack remains in the economy and therefore considerable monetary stimulus is still required. But supply disruptions appear to be lasting longer than we thought, and energy price increases are adding to current inflation rates. While our analysis continues to indicate that these pressures will ease, we have taken them into account for the dynamics of supply and demand.

What our resolve does mean is that if we end up being wrong about the persistence of inflationary pressures and how much slack remains in the economy, we will adjust. Our framework enables us to do just that.

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