In the lead-up to the 2016 agreement renewal, the Bank focused its review and research in three areas: The Level of the Inflation Target, Financial Stability Considerations in the Formulation of Monetary Policy, and Measuring Core Inflation. Read more about these three research priorities
Research Priorities, 2011-2016
In the lead-up to the 2016 agreement renewal, the Bank focused its review and research in three areas:
1. The Level of the Inflation Target
Canada targets 2 per cent inflation, the midpoint of a 1 to 3 per cent inflation-control target range. Since 2011, the experience of advanced economies with interest rates near the effective lower bound has put the 2 per cent target under increased scrutiny. The Bank undertook a careful analysis of the costs and benefits of adjusting the target.
Key Supporting Material
The Optimal Level of the Inflation Target: A Selective Review of the Literature and Outstanding IssuesBank of Canada research done prior to the most recent renewal of the inflation-control agreement in 2011 concluded that the benefits associated with a target below 2 per cent were insufficient to justify the increased risk of being constrained by the zero lower bound (ZLB) on nominal interest rates.
Unconventional Monetary Policy and the Great Recession: Estimating the Macroeconomic Effects of a Spread Compression at the Zero Lower BoundWe explore the macroeconomic effects of a compression in the long-term bond yield spread within the context of the Great Recession of 2007-2009 via a time-varying parameter structural VAR model.
2. Financial Stability Considerations in the Formulation of Monetary Policy
In 2011, the Bank concluded that monetary policy should be the last line of defence against financial imbalances. More recently, financial stability risks have been taken into account as part of the Bank’s risk-management approach to monetary policy. To more fully understand the circumstances under which it could be appropriate for the Bank to use monetary policy for financial stability purposes, the Bank continued its research into how best to integrate price stability and financial stability, the effectiveness of macroprudential tools, and the optimal mix of policy tools.
Key Supporting Material
On the Nexus of Monetary Policy and Financial Stability: Effectiveness of Macroprudential Tools in Building Resilience and Mitigating Financial ImbalancesThis paper reviews the Canadian and international evidence of the effectiveness of macroprudential policy measures in building resilience and mitigating financial imbalances. The analysis concludes that these measures have broadly achieved their goal of increasing the overall resilience of the financial system to the buildup of imbalances and increasing the financial system’s ability to withstand adverse shocks.
The financial crisis of 2007-09 and the subsequent extended period of historically low real interest rates have revived the question of whether economic agents are willing to take on more risk when interest rates remain low for a prolonged time period. This increased appetite for risk, which causes economic agents to search for investment assets and strategies that generate higher investment returns, has been called the risk-taking channel of monetary policy. Recent academic research on banks suggests that lending policies in times of low interest rates can be consistent with the existence of a risk-taking channel of monetary policy in Europe, South America, the United States and Canada. Specifically, studies find that the terms of loans to risky borrowers become less stringent in periods of low interest rates. This risk-taking channel may amplify the effects of traditional transmission mechanisms, resulting in the creation of excessive credit.
3. Measuring Core Inflation
While the Bank of Canada aims for low, stable, and predictable inflation, there will always be sharp movements in the Consumer Price Index (CPI), driven by volatile price changes in a small number of goods and services. In setting monetary policy, the Bank seeks to “look through” such transitory movements in the CPI, using “core” inflation measures as an operational guide to help it achieve the target for CPI inflation.
From 2001 to 2016, CPIX was the Bank’s preferred measure of core inflation. The properties of alternative measures of core inflation were re-examined to determine whether the Bank should continue the practice of identifying one preeminent measure as its operational guide, and if so, whether CPIX should continue to play that role. The Bank decided that starting in January 2017, it would cease using CPIX as its preferred measure of core inflation and focus instead on three new measures—CPI-trim, CPI-median and CPI-common.