The Bank of Canada and Financial Stability: A New Mandate?,

Abstract

In 2016, the Bank of Canada (BoC) and the government agreed to renew the 2 percent inflation target for five more years. The Bank’s own research concluded that it might be beneficial to show flexibility in responding to the build-up of financial imbalances. Recent history has shown that such conditions can produce asset-price booms that, once the inevitable bust occurs, may trigger a financial crisis. If financial imbalances are equated with greater risks to financial stability it is natural to ask whether this could conflict with the Bank’s mandate of targeting headline inflation with a plus or minus 1 percent tolerance range. We conclude that the Bank of Canada’s focus on price stability should not change. However, the Bank ought to be provided with greater latitude to become more forward-looking in highlighting potential threats, both domestic and foreign, to financial stability. We marshal historical and empirical evidence to make our case. A major impediment to burdening the BoC with additional responsibilities to maintain financial stability is that there is disagreement not only about when financial instability erupts, not to mention the form this instability can take, but also about its overall economic impact. Although calls to increase the burdens placed on central banks have become more widespread in recent years at the international level, policymakers also need to be made aware that such views are sometimes based on erroneous assumptions. These include: (i) All financial crises are the same. They are not. (ii) We know the size, timing and spillovers from financial crises. There is no one-size-fits-all response to financial crises. (iii) Financial stability policy is capable of being forward-looking. Unlike monetary policy, which has been forwardlooking for more than two decades, there is little evidence yet that the same is currently feasible to maintain future financial stability. Any renewal of the Bank of Canada’s inflation target, while explicitly acknowledging the Bank’s role as one of several agencies responsible for the maintenance of financial stability, should not confuse the public by adding the burden of meeting a goal it cannot reasonably achieve on its own. Unlike inflation, which inflationtargeting central banks have managed to control within tolerance ranges for more than two decades, financial stability requires a much wider set of tools. If the central bank were to become responsible for these tools, this would bring the institution dangerously close to making political-style decisions.