Monetary Policy in Unknowable Times

In his final speech as Governor of the Bank of Canada on May 25, Stephen Poloz summed up the unique challenges of monetary policy in these unprecedented times of the COVID-19 pandemic.

Bank of Canada

Stephen Poloz

I thought I could put the bow on my time as Governor by going to Edmonton and talking to a knowledgeable and engaged audience about uncertainty and monetary policy.

Then came the global tragedy we know as COVID-19. The clear imperatives for authorities around the world were to flatten the curve of infections, try to keep health-care systems from becoming overwhelmed and minimize preventable deaths. This led to severe but necessary restrictions on the movement of people and the shuttering of large sections of the economy. Policy-makers tried to cushion the blow through economic policies of historic size and scope, put in place for an undetermined length of time. Clearly, this is uncertainty in the extreme.

Today, there are encouraging signs in Canada that efforts to flatten the pandemic curve are paying off, and jurisdictions are taking tentative steps toward relaxing containment measures. But it is safe to say that the policy-makers who will guide us to whatever “normal” turns out to be will be dealing with unparalleled uncertainty. They will have to deal with all the unknowns surrounding the restart of shuttered sectors, the reconstruction of broken value chains, the unwinding of emergency measures and the unpredictable behaviour of consumers and business leaders. Some of the financial vulnerabilities already present in the economy will have grown worse, and other sources of vulnerability are likely to emerge. We are truly entering unknowable times.

Uncertainty has always been a key part of practical economics and policy making, and a large body of academic literature has developed over the years to provide guidance on how to make policy under uncertainty.

The Bank of Canada is an inflation-targeting central bank. We know that our policy actions can only affect inflation in the future, after a lag that reflects all the complexity of the monetary policy transmission process. This means it is crucial that we have a deep understanding of the economy to guide our policy decisions. We have developed increasingly sophisticated economic models to help inform

Mandate uncertainty has decreased in Canada since the early 1990s, when the Bank and federal government first spelled out an agreement on a framework for inflation targeting containing an explicit objective for inflation. The statement of the central bank’s policy framework in 1991 was followed by several moves to increase transparency.

Since 1995, we have regularly published the Monetary Policy Report (MPR), which provides a thorough update of the Bank’s economic outlook. In 2013, we started including Governing Council’s assessment of the risks directly in the press release, in part to emphasize our risk management process.

The problem with this common practice was revealed during the 2008-09 global financial crisis and subsequent Great Recession. The events illustrated a key weakness in most macroeconomic policy models at the time. In particular, they captured fewer and less-detailed linkages between financial markets and the real economy than ideal. They also revealed the need for the profession to work toward the goal of having a grand, unified model that adequately captures both macroeconomic and financial sector risks.

The essence of risk management is identifying the most important risks and uncertainties around the outlook. We examine the probabilities that the risks will be realized, consider alternative futures related to uncertainties and think about the potential consequences of making a policy error. We then choose a policy course that weighs these risks and uncertainties in order to best manage them. This process can entail a degree of flexibility around the inflation target itself, allowing inflation to return to target more slowly or quickly than on average, while keeping in mind that our target sits within a control range of 1–3 percent.

Given all the uncertainties and risks, it does not make sense to think a single, optimal path for our policy interest rate will be consistent with achieving our inflation target.

Notice that balancing the risks we face also requires taking into account the starting point for the economy, inflation and interest rates. Consider a situation where inflation is below target, as was often the case in the wake of the Great Recession. With the right monetary policy, an economic model will project a path for inflation that gradually rises toward the target. A forecaster might look at the projection and see that the risks to the inflation projection appear to be statistically balanced. In other words, inflation is just as likely to end up below that path as above it.

The application of risk management becomes particularly important as a wider array of risks enter into policy deliberations. In the aftermath of the global financial crisis, the economy took a long time to return to full capacity and inflation loitered below target. As a result, interest rates remained low for longer than expected, driving an increase in borrowing that showed up in household and housing sector vulnerabilities disposable income but cut their consumption steeply when their disposable income declines.

Financial vulnerabilities are also important because they can affect the “time trade-off” for economic growth. Specifically, a reduction in interest rates today will boost near-term economic growth through greater borrowing. Greater borrowing increases financial vulnerabilities, which in turn increase the risk that a future negative shock will have a magnified effect on the economy.

Before moving on, let me stress that taking a risk management approach to monetary policy is not a uniquely Canadian practice. The Chair of the U.S. Federal Reserve, Jerome Powell, describes the Fed’s approach to policy as having “three important parts: monitoring risks; balancing risks, both upside and downside; and contingency planning for surprises.” Possibly a better description of risk management would be to call it a “common sense approach,” since it reflects reality rather than the elegance of economic theories.

Offering routine forward guidance about the future path of interest rates obviously makes it easier for financial market participants to predict our policy. It can be argued that it makes markets more efficient because it reduces uncertainty. However, it does not reduce the total amount of uncertainty. Uncertainty is simply shifted onto the central bank’s shoulders.

When we decided to stop giving guidance, it was at a time when we could not fully explain why exports and business investment were weaker than our economic models were projecting. We wanted markets to appreciate the uncertainty we were facing and were concerned that providing forward guidance was giving participants a false sense of certainty. By being honest about the extent of our uncertainty, and by not offering false certainty, we managed to shift some of the uncertainty off our plate and put it back into markets.

It is normal that there will be times when market views about the future of the economy and interest rates, and those of the central bank, do not align. Indeed, normal market function depends on there being a variety of views about the economy. The central bank should not try to force alignment of market views with our own. Instead, we should be helping markets understand the thinking behind our policy decisions.

For financial market participants and the public to understand the nuances involved in risk management, we need to communicate our assessment of the events and issues that are influencing our decisions, while being honest about the high level of uncertainty inherent in policy making.

The Bank has come a long way in adopting a risk management approach to our inflation-targeting framework. But it is clear that the events of this year will be a massive test for everyone’s policy-making ability. We are entering unknowable times, and we will have to be nimble and innovative.

The questions are many and daunting. How and when will the global trading system recover? How will companies rebuild value chains? What structural damage will the pandemic cause? How quickly will labour markets recover, and how complete will the recovery be? Vulnerabilities linked to high levels of household debt will be accompanied by an increased pile of public debt—what kinds of policies will be needed to address this?

In the very short run, actions that are normally thought of as monetary policy moves will continue in support of the financial system. After all, a well-functioning financial system is a necessary precondition for effective monetary policy.

Keep in mind that monetary policy works by first having an impact on financial markets and prices of financial assets. This means that central banks can use some tools to restore market functioning in turbulent times and also to stimulate macroeconomic activity when financial markets are not disrupted. The same actions that we have taken to improve market functioning will become an important source of economic stimulus down the road.

Importantly, the economy was in very good shape when the pandemic hit: inflation was very close to target, and the unemployment rate was sitting at 40-year lows. Just as a healthy, fit individual is more likely to shake off COVID-19, so is the Canadian economy. The policy interest rate, however, had made it up to only 1.75 percent, which meant that monetary policy still had very little room to manoeuvre should a major event occur. Before the pandemic, there was a strong global consensus among central banks that the next major economic downturn would need to be addressed mainly through fiscal policies, with monetary policy playing a supporting role.

The pandemic created a sudden stop in economic activity that was not really addressable by monetary policy. Cutting interest rates to stimulate demand would have little effect when stores and factories were closed. Fiscal action, however, could be designed to support incomes, allowing the economy to “stop the clock” and wait for the pandemic to pass. Even so, the scale of the disturbance meant that monetary policy would need to deliver everything available to complement that fiscal action and support the economy, so the policy interest rate was moved rapidly to the effective lower bound of 0.25 percent. Further, we took a wide range of actions to ensure that financial markets continued to function so that credit would remain available to both households and firms.

This episode has meant some important changes to the conduct of monetary policy. First, the level of coordination between the Bank of Canada and the fiscal authority has been unusually high. This has even included unprecedented joint Governor–Finance Minister press conferences, a show of strength intended to buttress confidence in the economy. Throughout, the importance of the independence of the central bank has been underscored by both parties. It is well understood that the Bank’s ability to lend without limit must be backed up by the inflation target to anchor inflation expectations.

Second, the need to restore financial market function has prompted the Bank to launch an aggressive array of asset purchase programs. These programs are not only motivated by our mandate to promote financial stability, they are also essential if the cut in the policy rate to the effective lower bound is to find its way to the ultimate borrowers: households and firms. These actions include purchases of federal debt, provincial debt and corporate debt and are leading to a huge increase in the Bank’s balance sheet. This will reverse later as conditions gradually normalize. Through this episode, the lessons of 2008–09 led the Bank to eschew gradualism. Instead, the unconventional policy tools were deployed across the board, and aggressively so. In one press conference I was asked if perhaps we were overreacting. I responded that a firefighter has never been criticized for using too much water.

It appears that the approach has worked so far. Financial markets are performing well. We recognize that near-term cash demands from governments may put renewed strain on financial markets, but we are prepared for that possibility. Mostly, though, we are focusing our efforts on making sure the economy has a solid base for recovery.

With all the uncertainty surrounding the economic outlook, it is fair to ask about the relevance of a risk management approach for decision making. Although a minority of observers worry that these extreme policies will create inflation someday, our dominant concern was with the downside risk and the possibility that deflation could emerge. Deflation interacts horribly with existing debt, the two main ingredients of depressions in the past. In effect, then, we were saying that the downside risks were sufficiently dire that there were no relevant trade-offs for monetary policy-makers to consider. Picture the pandemic creating a giant deflationary crater in the middle of the economy; it takes what looks like inflationary policies to offset it.

The actions taken to counter the effects of the pandemic will clearly lead to higher indebtedness, for governments in particular. Getting the economy back onto its growth track—which is what is required if we are to hit our inflation target—is the surest means of servicing those debts over time. With the situation more like a natural disaster than a recession, there is reason to expect confidence to be buttressed by fiscal income supports and a reasonably swift return to growth for significant segments of the economy. Any structural damage, such as business failures and labour market scarring, will of course take longer to repair.

The extreme uncertainty we face today gives an added sense of urgency to the research being done at the Bank and elsewhere. This research will help us better understand some crucial issues as risk management continues to evolve. Ongoing research related to uncertainty includes work looking at spillovers in times of uncertainty and how macroeconomic uncertainty can lead firms to defer hiring.

Enhancing our understanding of real financial linkages will continue to be at the forefront. We have already learned a lot about the importance of taking into account household heterogeneity, including issues related to demographics and differences in income, debt and wealth. Our research will take advantage of microdata to develop a deeper understanding of how household heterogeneity matters for monetary policy transmission.

The pandemic is an example of uncertainty that will also force us to reconsider many fundamental ideas about how our economy can and should function. Many have said that when we eventually return to normal, that normal will be very different from what it was before COVID-19. The pandemic has revealed weaknesses in global and domestic supply chains, and it has ignited innovation in Canada and elsewhere that has revealed payoffs for flexibility.

There will be lessons to learn from how supply chains evolve. It will be interesting to see if future arrangements build in more redundancy of suppliers, and if more production of critical goods will be done domestically. More broadly, there may be changes to industrial structures as economies put less emphasis on global supply chains for products deemed essential for national health and security.

One clear impact of the pandemic is that many companies and employees have quickly moved to full-time telework arrangements once thought impractical, if not impossible. Meetings that people once thought had to be done face-to-face are now taking place virtually. Out of necessity, online commerce is expanding rapidly. It is worth considering whether these trends will accelerate digitization of the economy and more broad-based use of some technologies. It is also worth considering whether this will accelerate initiatives that contribute to a reduction in carbon emissions.

Finally, there will be lessons to learn about the effectiveness of various policies—fiscal, regulatory, financial and monetary—and how they interact.

If there is one common thread to this romp through recent economic history, it is that economists and policy-makers learn through experience. Uncertainty has been a common theme of my predecessors.

This brings a certain measure of humility to the policy table and makes us always wishing for more understanding, more insight and more clarity. Certainly, the lessons from the global financial crisis helped enormously in our approach to financial markets during the current pandemic.

This habit of continuously learning will be absolutely essential as we work our way through unknowable times. I have every confidence that we will find our way back to prosperity here in Canada, not just because of the strength of our foundations, but in the usual way–through hard work and ingenuity.

Excerpted from the Eric J. Hanson Lecture for the University of Alberta, May 25. 2020. The link to the full text is here. Reproduced by permission.