Steve Ambler is the David Dodge Scholar in Monetary Policy at the C.D. Howe Institute and professor of economics at the school of management, University of Quebec at Montreal; Jeremy Kronick is senior policy analyst at the C.D. Howe Institute.
Before Wednesday's Bank of Canada interest-rate hike, financial markets had priced in only a 50-50 chance of such a move. This means that half the market believed the bank would hold rates steady, creating significant market uncertainty.
Uncertainty has big economic costs for consumers and businesses alike. Does the bank need to continue to improve its communication to alleviate these costs? The short answer is yes – but the question is how.
The thinking on options tends to fall into two camps. In the first camp are those arguing for publishing a conditional interest-rate forecast. One of the primary benefits of such a conditional forecast is to provide realistic expectations to financial markets. Businesses and consumers alike are prone at times to irrationality (see the Toronto housing market), and the bank's forecasts can work to settle these markets down.
Another argument – which is especially relevant in Canada, where the Bank of Canada's governing council does not publish the minutes of its meetings – is that such a forecast would allow the airing of the internal debate surrounding the future path of interest rates. Markets would then have a better understanding of what economic variables are most important, and what is likely to tip the scales one way or the other.
The other camp argues that publishing such a forecast brings more variables into play, complicating things further for financial-market participants. The evidence on the success of central banks publishing conditional forecasts has been mixed. This camp argues, then, that continuing communication is a better tool and improvements in this area are the best path forward.
But here's the rub: If prior to an announcement, the market is pricing in 50-50 odds of a hike, both camps can still argue they are right. The conditional-forecast camp can argue that this is evidence that continuing communication alone has been unsuccessful, while the continuing-communication camp can argue that all we need is to improve the messaging.
So what to do? At a minimum, the bank can clarify two confusing issues that are at play.
First, despite robust and broad economic growth, inflation has remained stubbornly below the bank's 2-per-cent target. The breaking of the link between economic growth and inflation has confounded economists since the financial crisis. A rate hike in such an environment surprises market participants who believe an inflation-targeting central bank should keep rates steady. The rationale for increasing rates is missing since inflation remains muted (headline inflation was only 1.2 per cent in July) and it is not clear that strong economic growth will translate into inflationary pressure. The bank should continue to reinforce the idea that it looks to return inflation to target, not in this quarter, but in six to eight quarters. It could accomplish this by saying something stronger than noting in its latest communiqué that some measures of inflation have nominally increased "consistent with the dissipating negative impact of temporary price shocks and the absorption of economic slack."
The second issue is the prominence given to financial-stability considerations. Strong economic growth provides cover to deal with household-indebtedness concerns even if it has not led to inflation. Indeed, the bank's final sentence in the communiqué said: "Furthermore, given elevated household indebtedness, close attention will be paid to the sensitivity of the economy to higher interest rates." Interpreting this sentence is not straightforward. One interpretation is that the bank intends to be cautious with its future rate hikes so as not to provoke a crisis among Canada's most indebted households and firms. Another possible interpretation is that the bank intends to increase rates enough to definitively cool off the heated housing markets in Toronto and Vancouver. This degree of ambiguity can increase uncertainty.
We believe a conditional interest-rate forecast is an appropriate tool for the bank to give further consideration. However, if the bank decides against it, it should look to continue improving communication around the disconnect between GDP growth and inflation, as well as the importance of financial stability.