Why was the Bank of Canada so wrong for so long?

When you make the same mistake for four years in a row, hard questions have to be asked

Canada’s economic recovery is expected to evolve largely as anticipated in the October Report, with the economy returning to full capacity and inflation to the 2 per cent target in the third quarter of 2011 [Monetary Policy Report, January 2010]

…the Bank [of Canada] continues to expect that the economy will return to full capacity by the end of 2012 [Monetary Policy Report, January 2011]

…the economy is only anticipated to return to full capacity by the third quarter of 2013 [Monetary Policy Report, January 2012]

…the economy is now forecast to return to full capacity only in the second half of 2014 [Monetary Policy Report, January 2013]

…the Bank expects that the economy will gradually return to its full production capacity over the next two years [Monetary Policy Report, January 2014]

For four years, the Bank of Canada has been saying that the economy will return to potential—the level of activity where there are no inflationary or disinflationary pressures—over the two years following the publication of the forecast. The gap has not closed, and it continues to provide downward pressure on inflation, which has been below the Bank’s two per cent target for the past 18 months.

This pattern raises some questions, such as “Why does the Bank of Canada keep making the same projection over and over again?” The simplest answer is that’s what the Bank’s models keep predicting. When the model is hit with a negative shock, the economy converges to its previous state, and it would seem that according to the models that the Bank uses, the average time it takes to return to potential is about two years.

No one—least of all the people who make them—should be surprised when macroeconomic forecasts go awry. Even the best-calibrated economic models will be thrown off by things like political crises or natural disasters. The financial crisis in 2011—brought about by the U.S. debt crisis and events in the Eurozone—is an obvious example. But if you’re making the same mistake for four years in a row, some hard questions have to be asked.

Of course, asking hard questions is the easy part; the challenge is in answering them. In the Bank’s defence, the first part of the recovery relied on domestic factors and went more or less according to plan. The government implemented a textbook stimulus program that was timely, targeted and temporary. And Canadian consumers responded to low interest rates by shifting forward purchases of houses and other consumer durables. But there is a limit to how far this growth driver can be pushed before consumer debt goes from being a solution to being a problem in its own right, and we are probably closer to that tipping-point than we would like to be.

The next part of the recovery was supposed to have been driven by investment spending and by a recovery in the rest of the world, but it hasn’t worked out that way. So it could be argued that the Bank’s projections have been thrown off by a recovery in the rest of the world that has stubbornly refused to get off the ground. But a weak world recovery is hardly a convincing explanation: the Bank of Canada has all the tools it needs to carry out its inflation-targeting mandate. As we have seen recently, simply dropping the tightening bias has so far generated a 6 per cent exchange rate depreciation.

Some observers—including Econowatch’s Mike Moffatt—have been calling for looser monetary policy for many months now. (In Mike’s case, these calls go back to mid-2012.) So why did the Bank of Canada stick to its tightening bias for so long? I can think of at least two reasons that don’t amount to saying that the Bank simply dropped the ball—although that possibility can’t be dismissed out of hand:

The low-for-long problem: Everything else being equal, lower interest rates increase asset prices. The risk is that interest rates that are very low for very long could produce the sort of asset price bubbles—especially in housing—that have wreaked havoc in the US and Europe. There was some discussion in the months leading up to the renewal of the Bank of Canada’s inflation target about modifying the mandate to take into account developments in asset markets. These changes didn’t enter the new mandate, but it could be argued that to the extent that higher rates prevented house prices from rising more than they did, the Bank was preventing even greater deviations from target in the future. The fact that these concerns are receding may explain why the Bank recently moved away from the tightening bias.

The beggar-thy-neighbour problem: When it comes to currency wars, the Canadian dollar is like a ninja: it moves quickly, to great effect and no-one seems to notice it. But once the employment losses had been recovered—and while employment in the U.S. was still severely depressed—a weaker CAD could have generated frictions on the international front. So long as the Federal Reserve felt constrained in its efforts to implement unconventional measures such as quantitative easing, a lower Canadian dollar would be viewed as an unwelcome development in the U.S.. Again, now that the U.S. recovery seems to be on much more solid footing, these concerns are also easing.

There may be other scenarios. We’ll probably never know how and why the Bank let inflation drift below target for so long. It would be nice if the Bank’s Governing Council took a page from the Fed’s procedure book and published the minutes of its deliberations.

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