Canadian Monetary Policy Research Articles

What's so Special about Inflation Targeting? A Comparative Analysis of Recent Canadian and US Monetary Policy Frameworks

In the early 1990s, Canada was one of several countries to adopt an inflation-targeting framework for monetary policy. A noted exception to this group was the United States, where the framework for monetary policy was, as it had been for some time, informed by a dual mandate to maintain both high employment and low and stable inflation. By the late 1990s, the United States seemed to settle, in effect, on an implicit inflation-targeting framework for monetary policy. Nevertheless, whether the preferences of each central bank actually shifted toward minimizing inflation variability, and whether the magnitudes, opportunity costs, and timing of any such shifts were the same for both economies are questions that remain largely unexplored. In this article, I estimate these preferences from 1970 to 2009. Taken together, my results indicate that the Bank of Canada was more inflation averse overall; and both central banks grew more inflation averse over time.

Financial Stability: The Next Frontier for Canadian Monetary Policy

The monetary policy arrangement in Canada has proven very successful. Despite many and varied economic shocks, the Bank of Canada has established the necessary conditions under which the annual rate of inflation, as measured by the rate of change of the Consumer Price Index, has remained very close to its formal 2 percent target for more than 15 years. The recent financial crisis, however, has highlighted the fact that low inflation may not be enough to ensure the stability of the financial system and the economy in general. The goal of achieving and maintaining financial stability has become, in Canada and elsewhere, the next frontier of monetary policy. What is needed is a new Canadian institutional framework to oversee macro-prudential regulation, which would take a systemic approach to safeguarding the financial system as a whole, and clearly define the role of the Bank of Canada within it. It will require the federal government, first, to recognize the importance of the issue and, second, to take the necessary time to assemble the framework with the appropriate parties involved and to assign responsibilities clearly. Doing it right will involve bringing together various policy authorities with different perspectives, specialties, and primary mandates.

The changing relation between the Canadian and U.S. yield curves

The term structures of Canada and of the United States, two countries with historically interdependent economic ties, have been closely linked. We investigate the link between Canadian and U.S. yield curves and show previously strong correlations between yield curve components dissipate after Canadian monetary policy reforms in the early 1990s. We attribute the separated ties to the adoption of explicit inflation targets in 1991 and the maintenance of credibility in price stability as a central policy goal by the Bank of Canada. The effect is particularly evident in the diminished cross-country correlations of the short term bond yields. Additionally, there exists strong evidence of cointegration before the reforms, evidence which weakens after the policy change date. Lastly, the results on the term structure are shown using a vector autoregression with an endogenously determined break date for Canadian and U.S. estimates of the three-factor Nelson and Siegel (1987) yield curve model.

A Win-Win Monetary Policy in Canada

The Lucas critique has exposed the problem of the trade-off between changes in monetary policy and structural breaks in economic time series. The search for and characterisation of such breaks has been a major econometric task ever since. We have developed an integral technique similar to CUSUM using an empirical model quantitatively linking the rate of inflation and unemployment to the change in the level of labour force in Canada. Inherently, our model belongs to the class of Phillips curve models, and the link between the involved variables is a linear one with all coefficients of individual and generalized models obtained by empirical calibration. To achieve the best LSQ fit between measured and predicted time series cumulative curves are used as a simplified version of the 1-D boundary elements (integral) method. The distance between the cumulative curves (in L2 metrics) is very sensitive to structural breaks since it accumulates true differences and suppresses uncorrelated noise and systematic errors. Our previous model of inflation and unemployment in Canada is enhanced by the introduction of structural breaks and is validated by new data in the past and future. The most exiting finding is that the introduction of inflation targeting as a new monetary policy in 1991 resulted in a structural break manifested in a lowered rate of price inflation accompanied by a substantial fall in the rate of unemployment. Therefore, the new monetary policy in Canada is a win-win one.

Variations Across Canadian Regions in the Sensitivity to U.S. Monetary Policy

This paper contributes to the research on regional economic responses to monetary policy shocks in two ways. First, rather than just model the Canadian economy at the national level, we examine the impact of monetary policy shocks across five separate Canadian regions. The second extension of the literature is our focus upon estimating the impact from both Canadian and U.S. monetary policy shocks upon regional Canadian economic activity. The findings are broadly consistent with results from previous research modeling the national Canadian economy, but noteworthy regional differences are observed. Eastern Canadian regions, defined as Ontario (ON), Quebec (QU), and Atlantic (AT), exhibit greater sensitivity to Canadian monetary policy shocks than do Western Canadian regions. We also find that U.S. monetary policy shocks have a discernable impact on Canadian regional economic activity, but the impact varies across regions. For the three Eastern Canadian regions ON, QU, and AT, there is a significant impact upon regional economic activity from a U.S. monetary policy shock, but not for the two Western Canadian regions Prairie (PR) and West (WE). Moreover, the impact on ON, QU, and AT from a fed funds shock is quite similar to the impact from a shock to the Canadian Bank Rate.

Regime-switching monetary policy in Canada

This study captures regime-switching, monetary policy responses to financial market disturbances in Canada. Monetary policy is identified within a nonlinear, structural VAR framework with a regime-switching policy block that allows for contemporaneous policy reactions in a small open economy. The key finding is that monetary policy in Canada has undergone important changes in monetary policy regimes since the early 1970s that correspond to changes in operating procedures and medium-term inflation targets. Overall, the Bank of Canada is found to use a “hybrid” operating procedure in different monetary policy regimes, where it sets a monetary policy rate, while “leaning against the wind” to smooth exchange-rate fluctuations and to offset unexpected increases in long-term yields in order to maintain monetary conditions. Although the magnitude of the contemporaneous monetary policy responses are regime-dependent, the transmission of the responses through financial markets are regime independent. The study also constructs regime-switching measures of the overall level and relative volatility of monetary conditions that captures both the endogenous and exogenous components of the monetary policy response function.

Measuring regional effects of monetary policy in Canada

This article measures monetary policy shocks and examines whether the effects of such shocks have differential regional effects in Canada. We identify three possible sources of regional effects: differences in the importance of interest-sensitive industries, differences in the contribution of exports to output and differences in the proportion of small relative to large firms. Using the overnight interest rate as the instrument of monetary policy, we present impulse responses of industry output from a recursive vector autoregression, which incorporates a cointegrating relation. The results show that manufacturing and primary industries are the most interest sensitive. We conduct impulse responses of provincial employment from a monetary contraction. The results show that Newfoundland and Prince Edward Island (PEI), primary industry-based provinces, are strongly and adversely affected by a monetary contraction. Manitoba, Saskatchewan and Alberta, also primary-based, are also affected. Ontario, which is manufacturing-based, is also affected but to a lesser extent. The response of Quebec, New Brunswick, Nova Scotia and British Columbia are not statistically significant.

Parsing Shocks: Real-Time Revisions to Gap and Growth Projections for Canada

The output gap - the deviation of output from potential output - has played an important role in the conduct of monetary policy in Canada. This paper reviews the Bank of Canada's definition of potential output, as well as the use of the output gap in monetary policy. Using a real-time staff economic projection dataset from 1994 through 2005, a period during which the staff used the Quarterly Projection Model to construct economic projections, the authors investigate the relationship between shocks (data revisions or real-time projection errors) and revisions to projections of key macroeconomic variables. Of particular interest are the interactions between shocks to real gross domestic product (GDP) and inflation and revisions to the level of potential output, potential growth, the output gap, and real GDP growth.

Canadian monetary policy and the US federal funds rate

This article examines the empirical relation between the Canadian overnight rate and the US federal funds rate over the period 1975 to 2005. There is evidence of cointegration in the earlier part of the period from 1975 to 1988, but not in the post-1988 period to date. The inference is that the Bank of Canada has been pursuing monetary policy independently of the USA at least during the 1988 to 2005 period.

Electoral politics and monetary policy: does the Bank of Canada contribute to a political business cycle?

In this paper I apply the work of Abrams and Iossifov (Public Choice 129:249–262, 2006) to monetary policy in Canada to see if same political party affiliation is needed to produce evidence of political opportunism. After modifying their analysis to maintain the time-series consistency of their variables for Canada, I find that both an error correction model and a Taylor rule reformulation of their test generate evidence consistent with same party political opportunism, but only weakly so. On the other hand, I also find the presence of more traditional indicators of political influence. In particular, the data suggest that the election of a Liberal party government, a decrease in the degree of political competition, and to a lesser extent, the election of a minority government all positively influence the expansiveness of Canadian monetary policy.

Inflation targeting and monetary policy in Canada: What is the impact on inflation uncertainty?

Inflation uncertainty has been demonstrated both theoretically and empirically to lower real output. This paper examines the impact of inflation targeting in Canada on inflation uncertainty, as well as persistence. Our results indicate that inflation targeting lowered inflation persistence, but actually increased uncertainty. Such an effect may be due to the failure of the previous formal target, the M1 money supply, to successfully combat inflation.

Real and nominal effects of monetary policy shocks

Abstract. We employ the identification scheme of Kahn, Kandel and Sarig (2002) to analyse the impact of Canadian monetary policy on ex ante real interest rates and inflationary expectations. First, we decompose nominal interest rates into ex ante real rates and inflationary expectations using the methodology of Blanchard and Quah (1989). Then we estimate a recursive VAR model with innovations in a monetary aggregate and the overnight target interest rate as alternative measures of monetary policy shocks. We find that a negative policy shock raises both nominal and ex ante real interest rates, lowers inflationary expectations and real industrial output, and appreciates the Canadian dollar.

A No-Arbitrage Analysis of Macroeconomic Determinants of Term Structures and the Exchange Rate

We study the joint dynamics of macroeconomic variables, bond yields, and the exchange rate in an empirical two-country New-Keynesian model complemented with a no-arbitrage term structure model. With Canadian and US data, we are able to study the impact of macroeconomic shocks from both countries on their yield curves and the exchange rate. The variance decomposition of the yield level shows that US monetary policy and aggregate supply shocks explain a majority of the unconditional variations in Canadian yields. They also explain up to 50% of the variations in the expected excess holding period returns of Canadian bonds. In addition, Canadian monetary policy shocks explain more than 70% of the variations in Canadian yields over short and medium forecast horizons. It also explains around 40% of the expected excess holding period returns of Canadian bonds. Both Canadian and US macroeconomic shocks help explain the dynamics of the exchange rate and the time-varying exchange risk premium.

Is the Quantity of Government Debt a Constraint for Monetary Policy?

This paper derives an interest rate rule for monetary policy in which the interest rate response of the central bank toward an increase in expected inflation falls as debts increase beyond a certain threshold level. A debt-constrained interest rate rule and the threshold level of debt are jointly estimated for Canada during the first decade of its inflation targeting regime of the 1990s. There are three main findings of this paper. First, a high government debt could constrain monetary policy if government spending-rather than taxes-is expected to adjust in future in line with debt service costs. The 'constraint' operates through an altered policy transmission mechanism through changes in the IS curve. Second, the effects of the debt-constraint on monetary policy are quite different during booms and recessions. Third, empirical estimates show that Canadian monetary policy might have been constrained by a high government debt-GDP ratio during the 1990s. Policy was less loose than what inflation indicators called for.

Bank lending, credit shocks, and the transmission of Canadian monetary policy

This paper uses a sticky-price dynamic general-equilibrium model to study the role of bank lending as a transmission mechanism of monetary policy shocks and to assess real effects of exogenous credit shocks under alternative monetary policy Taylor-type rules. Financial frictions, which are modeled as spreads between deposit and loan interest rates, depend on economic activity as well as on exogenous credit shocks. A general finding is that, even though almost all of the real effects of a monetary policy shock come from the price rigidity, imperfections in credit markets are responsible for their significant amplification. Nevertheless, if the central bank follows a forward-looking inflation targeting rule, bank lending is responsible for transmission of monetary policy shocks even though prices are flexible. Moreover, exogenous credit shocks account for substantial fractions of output, inflation, and nominal interest rates fluctuations in the short and medium terms.

Nominal rigidities and monetary policy in Canada

This paper develops and estimates a dynamic, stochastic, general-equilibrium model with price and wage rigidities to analyze monetary policy in Canada. A monetary policy rule allows the Bank of Canada to systematically change the short-term nominal interest rate in response to deviations of inflation, output, and money growth. The structural parameters of the model are estimated econometrically using a maximum-likelihood procedure with a Kalman filter. The estimates reveal that either price or wage rigidities are key nominal frictions that generate real monetary effects. Furthermore, the simulation results show that the Bank has, since 1981, increased the short-term nominal interest rate in response to exogenous positive demand-side disturbances, and used modest but persistent reductions in the nominal interest rate to accommodate positive technology shocks.

Monetary Policy and Economic Activity in Canada in the 1990s

Growth in output and employment in Canada in the 1990s did not match that of earlier decades, or that in the United States. Monetary policy rules estimated for each country illustrate important policy differences between Canada and the United States. In the early 1990s Canadian monetary policy placed primary emphasis on a sharp reduction in inflation and performance was weak. United States' monetary policy balanced inflation control and output stabilization, and performance was strong. These findings argue for future Canadian monetary policy that provides support for stable output growth and inflation targets, not just inflation reduction and targets.

Reflections on October 6, 1979, and Its Aftermath

The Bank of Canada was facing problems similar, but not identical, to those facing the Fed in 1979. Following the adoption of targets for the monetary aggregate M1 in November 1975, inflation (as measured by the 12-month increase in the consumer price index [CPI] excluding food and energy) had decelerated from about 9 percent in the second half of 1975 to a low of about 51/2 percent in mid-1978. This reflected policies aimed at a gradual disinflation: monetary policy through a reduction in M1 growth from 1975 on and wage and price controls over the 1975-78 period. Subsequently, there was a marked intensification of inflationary pressures in the Canadian economy from both external factors (the rise in commodity prices and U.S. inflation) and internal factors (the pressure of demand in the Canadian economy), in spite of the continued deceleration of M1. Inflation increased to about 8 percent by mid1979. At the time, a lot of emphasis for the rise in inflation was placed on special factors, especially the exit from wage and price controls and the effects of the renewed rise in oil prices related to the revolution in Iran in early 1979. In retrospect, an important part of the explanation for the divergence of the path of inflation growth from that of M1 growth was the high interest rate elasticity of the demand for M1.1 This meant that, when M1 growth tended to rise above target as a result of an increase in price inflation, the rise in interest rates needed to keep M1 on target was INTRODUCTION C anada is the quintessential “small open economy.” It has very close ties with the United States in both trade and capital movements. On the financial side, interest rate movements in the United States can affect Canada fairly quickly through their influence on the exchange rate and on domestic interest rates. As a result, economic and financial developments in the United States have an important influence on the Canadian economy and on policymaking in Canada. The changes in the Federal Reserve operating procedures of October 6, 1979, and the subsequent wide fluctuations in short-term and longterm U.S. interest rates had significant effects on interest rate and exchange rate developments in Canada and thereby on Canadian monetary policy. This paper examines a variety of issues related to these developments. The next section of the paper sets out the background to the Canadian economic situation in the latter part of the 1970s. In the following section, I examine the analyses carried out in the Bank of Canada in response to the announcement of October 6, focusing particularly on the analysis of the new operating procedures announced on that date. The subsequent section of the paper looks at the effects of the change in the U.S. policy framework and of the resulting U.S. interest rate movements on Canadian financial developments and on the way they affected policymaking in Canada. A final section offers some concluding remarks. 1 There may also have been insufficient adjustment for the downward shift in M1 in response to financial innovations when the targets were rebased.

Evaluating New‐Keynesian Models of a Small Open Economy*

AbstractWe suggest a strategy to evaluate members of a class of New‐Keynesian models of a small open economy. As an example, we estimate a modified version of the model in Svensson [Journal of International Economics (2000) Vol. 50, pp. 155–183] and compare its impulse response and variance decomposition functions with those a structural vector autoregression (VAR) model. The focus is on responses to foreign rather than to domestic shocks, which facilitates identification. Some results are that US shocks account for large shares of the variance of Canadian variables, that little of this influence is due to real exchange rate movements, and that Canadian monetary policy is not adequately described by a Taylor rule.

A New Consensus on Monetary Policy?

ABSTRACT By analyzing the documents issued by the Bank of Canada, an original monetary policy can be seen. The Canadian monetary policy tries to maintain its autonomy, whilst at the same time respecting floating exchange rates. The numerous innovations are the foundation of a New Consensus on monetary policy. Far from the dilemma rule versus discretion of the former Monetarist and Keynesian methods, a new dilemma will be the focus: that of credibility versus confidence. Here, the anticipations of the economic agents, the behavior of financial markets and the price of assets play a dominating role. Based on the innovative experiment of the Bank of Canada during the 1990s, the characteristics of the New Consensus will be explained. Far from making independent central banks some high-powered institutions, it shows them instead to be “statues with feet of clay”.