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Why the Bank of Canada needs to prepare Canadians for rate hikes

We have been stuck in a low-interest period for almost a decade now, and with that apparent inertia comes the challenge of knowing when to start reversing course. Last Wednesday's interest rate announcement and press release by the Bank of Canada were slightly more hawkish (or slightly less dovish) in tone than its previous announcement, but it gave no explicit hints that rate increases are on the immediate horizon. However, stronger economic data that support the bank's own internal forecasts suggest they should be. At a minimum, communication with the public should start to prepare the market for such increases.

To understand why, let's review the concept of the neutral rate of interest. In the world of central banking, the neutral rate of interest represents the policy rate consistent with output at its potential level and inflation equal to target. The Bank of Canada sets its interest rate to achieve such a well-functioning economy within a six-to-eight quarter horizon. Therefore, the current policy rate of 50 basis points represents the stimulus required to get us to potential, with inflation at target, over this time period. In last April's Monetary Policy Report, the bank projected that output will return to potential by the first half of 2018, with headline inflation sustainably returning to its 2 per cent target.

So what's the problem? The issue is the Bank of Canada's estimate for the neutral rate of interest, which it believes sits between 2.5 and 3.5 per cent. If the bank expects output to hit potential and inflation to be at target some time in the first half of 2018, the policy rate would have to increase by some 200 basis points (from 50 to 250) in one year. In a world where 25-basis-point changes are the norm, that would require an increase at every Bank of Canada interest rate announcement between now and the middle of next year.

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The private sector appears to give the neutral rate little concern. A recent Bloomberg News survey found that none of the 23 economists surveyed thought the bank would increase rates at Wednesday's announcement. Furthermore, economists didn't expect the next rate hike to occur until the second quarter of 2018, the same time frame the economy will supposedly return to potential.

What can the bank do? While it is not realistic to get to its estimate of the neutral rate over the next 12 months, the bank can start preparing the market for rate hikes in much the same way the Fed has done in the United States. Forward guidance has proven to be a useful tool for central banks around the world coming out of the financial crisis. The tool allows markets to adjust in advance of expected rate changes, creating a more stable environment for consumers and businesses.

Of course, all of this depends on a strong Canadian, and global, economy. So far in 2017 this has been the case, after a strong finish to 2016. The global economy appears in good shape, an improved labour market has stimulated consumer spending, business investment has gone up, and oil prices have rebounded – and although they have not returned to their previous highs, the economy has adjusted. Risks remain, including household debt levels, and inflation that has stayed stubbornly below 2 per cent – even if only mildly. But on balance, the strengths appear to outweigh the weaknesses.

If the bank believes its forecast of potential output and inflation, and believes its estimate of the neutral rate to be accurate, the time to prepare for rate hikes is now. If the bank foresees headwinds or risks that justify a policy rate substantially below the neutral rate, it would be best to continue highlighting what these are.

Steve Ambler is the David Dodge Chair in Monetary Policy, and Jeremy Kronick is a Senior Policy Analyst at the C.D. Howe Institute.

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