Deputy Governor Sharon Kozicki talks about setting monetary policy when supply shocks have more influence on inflation.
A shift in the drivers of inflation
The Bank of Canada reviews and renews its monetary policy framework every five years to ensure it is well equipped for the challenges of the future. The next renewal with the federal government will happen later this year.
The framework sets a 2% inflation target, with some flexibility for how long it takes to return inflation to 2% when it deviates from that target. This approach has served us well, and we don’t plan to change it.
But the world has changed a lot in the past five years, and one big shift the Bank is focused on is how supply-side developments have become more important drivers of inflation. The supply side of the economy refers to factors that affect the availability of goods and services. These factors include production costs and how efficiently workers and capital are used.
Before the COVID-19 pandemic, inflation was typically driven by demand:
- A weak economy, characterized by weak demand, was typically associated with inflation below the 2% target.
- A strong economy, driven by strong demand, was typically associated with inflation above target.
But supply-side shocks can push the economy and inflation in opposite directions—toward a weaker economy and inflation above target. This presents difficult choices for central banks because tightening monetary policy to restrain inflation tends to weaken the economy further.
The bottom line is this: to prepare for the future, we need to understand the implications of a wide variety of supply-side developments.”
Supply shocks are more challenging to manage
A recent example of a major supply shock is the disruptions to global supply chains during the pandemic, which led to widespread shortages of goods. Other supply-side forces reshaping the economy today include:
- the reconfiguration of global trade
- the rise of artificial intelligence
- an aging population
- geopolitical tensions
- more frequent severe weather events
When supply-side developments have more influence on inflation, policy-makers need to consider how large and persistent the impact on inflation is likely to be. They must also judge which side of the trade-off is more concerning—high inflation or weak economic activity—and how broad-based the inflation impact is across the economy.
Sometimes it makes sense to “look through” the impact on inflation if it is likely to be short-lived or have limited effects. Other times the Bank must act, even if the economy is weak. The key is using the flexibility in our framework to bring inflation back to target while minimizing negative effects on the economy.
Improving our diagnosis and risk management
It is challenging to gauge in real time the size, persistence and nature of a shock. That is why we are strengthening our tools for diagnosis and risk management.
We are enhancing our economic models and using scenario analysis to test different paths for monetary policy. We are gathering intelligence beyond traditional data, including through talking with business leaders and households. And we continue to communicate with Canadians in ways that help them understand our decisions.
With every monetary policy decision we take, Canadians count on us to be equipped to identify and manage risks. And they count on us to deliver low and stable inflation despite the challenges that supply-side developments present.”