Still Confused

It’s official, the Bank of Canada and its inflation targeting regime is still relevant.  The head guy told us so.  Thank goodness because I am not sure who would hire the 1000 economists working there if they decided to shutter the institution. (Although Finance looks like it needs some good people to explain the implications of making arbitrary and politically motivated changes to tax policy in the name of “fairness”). 

The Governor’s speech earlier this week tried to convince the country that they still have a handle on this inflation targeting stuff.  They remain convinced that the laws of aggregate demand and supply have not been rescinded and remain the fundamental drivers of inflation.   The recent consistent undershooting of inflation in Canada can mostly be explained away by transitory factors.  The Bank, he assured us, understands these fundamental drivers well enough to do policy.   A couple of tenths here and there on inflation are not really relevant in the grand scheme of things.  Being somewhat close to target works in horseshoes, hand grenades and now apparently monetary policy.

The Bank obviously remains confident in the framework it uses to make policy decisions. They expect inflation to trend around the mid-point of their inflation target when the economy is operating at full capacity and inflationary expectations are well anchored.  The fact that trend inflation remains below target and the fact that inflationary expectations are well anchored around the target level, tells them that the economy is not at full capacity yet.  This plus OFSI’s stricter underwriting criteria and the incorporation of some tail risk of Nafta collapsing appears to have led Captain Poloz to set the tasers to caution.  

I can understand there is a lot of noise in the current environment that potentially could lead to a number of outcomes for the economy, both better and worse than currently forecast.  I also get the instinct to do no harm as one tries to separate the signal from the noise and let more data roll in.  

What I don’t understand is a Bank that believes in supply and demand being the fundamental drivers of inflation but shifting to a much more dovish stance, in fact becoming “more preoccupied with downside risks to inflation” when we haven’t been this close to full employment in almost ten years.  The October MPR states that the economy is currently operating close to capacity now and inflation is expected to increase close to 2% over the next six months.  Given that the economy is either at or very close to full capacity, and is expected to grow above potential for the next couple of years, I struggle to reconcile this with a dovish policy setting.  The same guy that says that rate moves need to be done with caution also tells us that “the closer we get to full output and employment, the greater risk that inflation pressures will appear”.  This just seems so inconsistent to me.        

I keep beating the same drum, but to me, there continues to be a large divergence between monetary policy consistent with the gap and the outlook laid out in the MPR (virtually no gap now) and the outlook and the output gap that we are not privy to that seems to be behind the the concern of downside risks to inflation and has prompted a “cautious” policy stance.  If it was any other Governor I would almost think he was trying to keep the currency at bay.  But this Gov?  Naw.