Monetary policy: It’s perfectly imperfect

Governor Tiff Macklem speaks about the effectiveness—and limitations—of monetary policy. He highlights how raising and lowering the policy interest rate ultimately keeps inflation low, stable and predictable, despite significant shocks to the economy.

Monetary policy works

The Bank of Canada began targeting an inflation rate of 2% in 1991. Since then, inflation has stayed at or near the target—despite several shocks to the economy.

The bursting of the dot-com bubble in 2000, the terrorist attacks of September 11, 2001, the 2008–09 global financial crisis and the 2015 oil price shock all presented unique challenges for central bankers around the world. Monetary policy isn’t an exact science. With hindsight, we see that in some cases stimulus measures were withdrawn too quickly, or not quickly enough.

Regardless, by raising and lowering policy interest rates, central banks pushed through these shocks, influenced demand and restored price stability.

The COVID-19 pandemic challenged us

The COVID-19 pandemic caused the biggest shock to date. Large portions of the economy shut down overnight, and millions of Canadians lost their jobs. At first, deflation—a rapid fall in prices—was a real concern.

The Bank drew on the lessons we learned from previous shocks and took quick, decisive action. We cut the policy rate to near-zero and introduced quantitative easing for the first time. Monetary policy worked together with government fiscal actions to keep the Canadian economy afloat and prices relatively stable.

When the economy reopened, demand outpaced supply. The Bank pivoted from dealing with the risk of low prices to a situation where prices rose rapidly. Inflation spiked to a four-decade-high of more than 8%. We raised our policy interest rate in response.

We’re seeing results. The policy rate is at 5% and inflation has come down to 3.4%. But the path back to the 2% target will be slow and bumpy.

Monetary policy is not without limitations

Monetary policy has been likened to a blunt instrument, because it is not a precise tool. It can’t target specific groups, sectors or regions. Furthermore:

• Monetary policy can’t prevent short-term swings in prices. Any changes to the policy rate usually take a year or longer to work their way through the economy. Central banks don’t react to temporary ups and downs in prices, and instead focus on keeping overall inflation on target over the medium term. For the Bank of Canada, that means targeting the middle of our 1% to 3% band.
• Canadians are concerned about housing supply and affordability. Changes to the policy rate influence mortgage rates and overall demand. But monetary policy cannot solve the underlying structural issues that are behind the lack of housing supply.
• Low, stable and predictable inflation promotes economic stability. By raising or lowering rates, we can cool or boost demand in the short term. However, longer-term economic growth depends on a growing population and improvements in productivity—neither of which are sensitive to interest rates.

While monetary policy has some limitations, history has proven it is effective at doing what it does best—controlling inflation.