Monetary policy brings benefits—but has limits

In his first speech of 2019, Governor Stephen S. Poloz explains that monetary policy is a powerful tool to promote our economic welfare. But he also notes that it has some key limits that need to be better understood in the face of uncertainty.

Inflation targeting has worked

For more than 25 years, our focus has been on keeping inflation low and stable. By lowering or raising interest rates to heat up or cool down the economy, we aim to keep inflation at 2 per cent.

The policy has worked. With lower inflation and lower interest rates:

• the economy adjusts more quickly to unexpected events
• businesses and households can make longer-range plans
• wage negotiations are more predictable
• economic cycles are less severe
• unemployment is lower on average and less variable

Interest rates are an imperfect tool

While inflation has largely been tamed, there are limits to monetary policy:

• We have only one tool, the policy interest rate, for one target, inflation.
• Keeping interest rates low can lead to borrowers to take on dangerous amounts of debt.
• There is so much uncertainty around monetary policy that it limits how precise we can be.

Very low interest rates since the 2008 financial crisis have encouraged debt levels that have become risky for the entire economy.

Movements in the interest rate also take time to filter through the economy. This means we need to use a lot of judgment to gauge where the economy is going.

The mix of policies matters

Fortunately, monetary policy is not the only game in town.

Fiscal policy and financial regulation were deployed following the crisis, notably with stress tests on mortgages, to support better outcomes for the economy.

Relying too much on monetary policy can be dangerous. If we hadn’t raised interest rates over the past few years, not only would inflation be higher, but Canadians would also be further in debt and house prices would still be rising quickly.

Uncertainty means we are learning as we go

One important uncertainty that we are dealing with today is the impact of higher interest rates on highly indebted Canadians.

As we’ve gradually raised the interest rate, we’ve watched how households react to the higher costs.

Uncertainty about the future of the global trade environment is also high right now, which clouds the future of business investment.

We will watch the data as they come in and use judgment to deal with the uncertainties and manage the risks.