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Ken Boessenkool and Mike Moffatt: Macklem can't afford another bad call
We urge the governor to avoid leaping to overly rose-coloured conclusions.
“I have put a lot of emphasis today on the things we don’t know.”
— Stephen Poloz, November 3, 2014
“So we expect that inflation is going to remain weak for some time, and given that it's already around zero, we're more worried about disinflation than inflation…”
— Tiff Macklem, July 15, 2020
By: Ken Boessenkool and Mike Moffatt
Tiff Macklem will shortly make public the next step for interest rates in Canada. As he does so, we would urge circumspection.
To explain why, we will tell a tale of two central bankers.
And indeed, “it was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness,” to quote the famous novel. The worst of times for the first central banker was the global financial crisis of 2007 to 2009. The worst of times for the second was the global pandemic we’ve faced for nearly three years now, and it’s not entirely done yet. The wisdom of the first was to cling to uncertainty. The foolishness of the second was to cling to certainty.
And with those links stretched to incredulity, let's go back and tell the story.
Stephen Poloz was made governor of the Bank of Canada in mid-2013. And while the global financial crisis's technical end was four years old and affected the United States substantially more than Canada, it was clearly not yet entirely in the rear-view mirror.
For example, in December of 2012, the U.S. Federal Reserve continued to provide “forward guidance” that interest rates would stay low for the foreseeable future. Further, quantitative easing — the purchase of financial instruments by central banks to further ease monetary policy when interest rates arguably cannot go much lower — continued through 2014. And unwinding those purchases didn’t start in the United States until 2017.
Quantitative easing of the magnitude used by the United States Federal Reserve during this extended period was unprecedented. Critics of this extended period of extremely loose monetary policy saw inflation around every corner. Yet, in hindsight, we know that inflation never was a significant threat. Not only was there not excess inflation, but inflation even stayed below target, just as it had when the Bank of Japan employed quantitative easing.
This was the environment in which Poloz was appointed. A full 18 months into his term, and not entirely without foreshadowing, he gave a landmark speech entitled “The Legacy of the Financial Crisis: What we know, and what we don’t.” The quote at the top of this piece is taken from the conclusion of that speech, in which Poloz lays out all of how the global financial crisis — that hit Canada much less hard — had made the job of a central banker much more uncertain.
Rather than let the economic models utilized by the Bank of Canada dictate the path of monetary policy and any Canadian “forward guidance,” Poloz stated that the Bank of Canada would be “totally data dependent.” And through the remainder of his term, Poloz would frequently repeat the mantra of “what we know and what we don’t,” often to the chagrin of market participants who crave certainty.
It is often said that monetary policy has only one tool — interest rates — and it should therefore target only one outcome — the inflation rate. Which we have no quibble with, so far as it goes. But monetary policy operates with long and uncertain lags — from 12 to 24 months. Central bankers cannot move interest rates today and see the effect on inflation tomorrow.
This lag means that there is another, more ephemeral, tool in the central bankers' toolkit — the tool of credibility. If citizens, businesses and market participants believe that the bank has things essentially correct — due to a long track record of success in holding inflation within a target range, for example — then they will give the bank a lot of leeway in the conduct of implementing their policy. In short, they will find the Bank of Canada credible.
Besides a strong track record, credibility can also be managed by rhetoric — by which we mean Central Bank communications. Bank governors are notoriously careful with their words. As well they should be.
Seen in that light, it would seem that Poloz's deliberate uncertainty strategy carried a decent-sized risk. Citizens, business and market participants could well have said, and probably did, “Well, if he doesn’t know what is going on, who does!?”
Yet we would argue that being uncertain is a much lower blow to credibility than being certain but wrong. And not only does being uncertain put a proper hedge on credibility, but it can also give the governor more range of motion when inflation moves in unanticipated directions.
This takes us to our second central banker, the current Bank of Canada governor, Tiff Macklem. It takes quite a search to find the kind of uncertainty in Macklem’s communications that regularly found its way into Poloz’s.
This isn’t to say you can’t find it, but here is a typical example from June 2020, where in one breath, Macklem outlines (correctly in our view, if not in retrospect) sources of profound uncertainty, and in the very next breath states that within a mere month’s time, he will be able to provide “a central planning scenario” to “begin to answer some of these questions.” The shift from uncertainty to certainty is breathtaking and worth quoting in full:
The pandemic has created a fog of uncertainty, and this has greatly complicated our ability to generate a clear outlook for growth and inflation. The course of the coronavirus is the biggest source of uncertainty. Beyond that, we don't know how global trade and supply chains will evolve, or what will happen with domestic supply and demand. We don't know how consumer and business confidence will rebound, or whether the pandemic will lead to lasting changes in savings and spending habits.
With the economy at least stabilizing, we are starting to get some line of sight, and as more data arrive, we can begin to answer some of these questions. In our July Monetary Policy Report, we expect to be able to provide a central planning scenario for output and inflation, with a discussion of the main risks around that scenario. Going forward, we will assess incoming information relative to that scenario.
And he was true to his word. Following the release of the July 2020 Monetary Policy Report, Macklem gave the quote at the head of this piece, to wit, “So we expect that inflation is going to remain weak for some time, and given that it's already around zero, we're more worried about disinflation than inflation…”
As the chart above shows, you would be hard-pressed not to point to precisely the date of that remark as the moment when inflation started its precipitous and worrying rise.
Talk about a blow to Macklem’s credibility and manoeuvrability to be “data dependent.” And we’ve not mentioned the opening this gives Bank of Canada critics — partisan or otherwise — to cast aspersions on Macklem’s monetary policy conduct.
With most inflation indicators now appearing to trend downward, we urge the governor to avoid leaping to overly rose-coloured conclusions. Instead, we would urge him to be much more circumspect — Polozian, if you will — and exercise caution and let the conduct of monetary policy in the coming months to be much more “data dependent” than model dependent.
After all, the last thing he can afford is another bad call.
Ken Boessenkool is founding partner at Meredith Boessenkool and lectures at the Max Bell School of Public Policy at McGill University. Mike Moffatt is the senior director of policy at the Smart Prosperity Institute and an assistant professor in the Business, Economics and Public Policy group at Ivey Business School, Western University.
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