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With inflation AWOL, Bank of Canada must drop tightening bias

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The Bank of Canada has no good reason to continue with its tightening bias on monetary policy. But it's getting some pretty compelling reasons to drop it.

Canada's consumer price index (CPI) inflation – the single anchor defining the central bank's interest-rate policy – came in at an ice-cold 0.7 per cent year-over-year in May. On a month-to-month basis, inflation did pick up a little after dipping in April, but overall, consumer prices have barely moved in seven months. The so-called "core" CPI – the one the Bank of Canada pays the most attention to, which excludes the most volatile sectors such as food and energy – was dead flat for the third straight month, and is up just 1.1 per cent year over year.

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The Bank of Canada is legally bound to use inflation as its guide for determining rate policy – defined specifically as maintaining inflation with a target band of 1 to 3 per cent. Operationally, that means aiming to have core inflation around the 2-per-cent sweet spot. In recent months, core inflation has not only been well below this midpoint, but has been flirting with falling out of the target band. What's more, the central bank doesn't forecast much pick-up in the next few quarters; it doesn't expect total or core inflation to return to 2 per cent until mid-2015 – two years from now.

Yet the central bank has been clinging to language in its eight-times-a-year monetary policy statements saying that, eventually, "some modest withdrawal will likely be required" of its current highly-stimulative low policy rate. The market has quite rightly taken this persistent message as code that the bank continues to lean toward an increase in rates as its next direction (whenever that might be), rather than any possibility of any cuts to the current 1.00-per-cent policy rate.

Why, with inflation signalling nothing like a need for tightening, would the Bank of Canada maintain this tightening bias anyway?

The espoused logic is that this threat has been keeping a lid on consumer debt – the central bank's most feared threat to economic and financial stability. This is a torch lit by the Bank of Canada's recently departed boss, Mark Carney, and it appears to be one his successor, Stephen Poloz, has picked up. Just this week Mr. Poloz cautioned Canadians that "interest rates will rise at some point," and they had better keep their debts in order.

But even on this front, the bank's tightening bias is unnecessary. Consumer debt growth has already slowed markedly. More to the point, the financial market is already doing what the central bank has been threatening to do: The ongoing selloff in the long-overheated bond market is substantially raising interest rates.

In this circumstance, the central bank might better serve Canada's economic needs by stepping away from the threat of eventual tightening. It should use its policy heft to lean against potentially disruptive financial-market extremes (such as a rapid and volatile unwinding of the bond market), rather than lean with them.

Mr. Poloz has a decision to make on July 17, the next policy statement date. It's time to remove the tightening-bias language, and turn a new page on a policy that has outworn its usefulness.

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David Parkinson is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow him on Twitter at @parkinsonglobe .

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About the Author
Economics Reporter

David Parkinson has been covering business and financial markets since 1990, and has been with The Globe and Mail since 2000. A Calgary native, he received a Southam Fellowship from the University of Toronto in 1999-2000, studying international political economics. More

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