February 5th, 2024, Bank of Canada Governor Tiff Macklem delivered a speech titled “The effectiveness and the limitations of monetary policy” before the Montreal Council on Foreign Relations (CORIM). Here National Bank Economists highlight some of the important elements of the speech and provide their overall assessment below, in the Bottom Line:

Monetary policy works: “Monetary policy works to control inflation—not perfectly, not quickly, and not without pain. But it works.”

Albeit with a delay: “Monetary policy doesn’t always get it exactly right in the moment, but it’s very effective in controlling inflation over the medium term.”

But it can’t do everything: “[Monetary policy] cannot target specific groups or sectors. We cannot raise the policy rate in Quebec but lower it in the Maritimes. We cannot raise returns for savers but lower the cost of capital for companies that want to invest.”

It can’t boost long-term growth: “Monetary policy can only boost economic growth in the short run. Long-run growth comes from two sources: population growth and productivity growth. Neither are significantly affected by interest rates… For 25 years, Canada has been very good at growing its economy by adding workers… But productivity growth, by which I mean more output for the same amount of work, has disappointed. This is a problem because higher productivity pays for higher wages and underpins a rising standard of living.”

It is not the right tool to deal with the housing shortage: “Housing affordability is a significant problem in Canada—but not one that can be fixed by raising or lowering interest rates. Housing supply has fallen short of housing demand for many years. There are many reasons why—zoning restrictions, delays and uncertainties in the approval processes, and shortages of skilled workers. None of these are things monetary policy can address.” “Monetary policy can particularly affect demand in the short run. But it can’t address long-running structural problems on the supply side, which are fundamental to affordability.”

Which means shelter costs is likely to keep inflation elevated despite higher rates: “Shelter price inflation… has been elevated for several years and increased further in the past six months. It is now the biggest contributor to above-target inflation. This partly reflects the impact of increases in our policy rate on mortgage interest costs. But high shelter cost inflation also reflects increases in rents and other housing costs, which are more related to the structural shortage of housing that I mentioned earlier. That is not something monetary policy can fix. But it is something we need to understand and factor into monetary policy because it is affecting the cost of living for Canadians.”

Making the return to the 2% target more arduous: “Putting this all together, the resulting push and pull on inflation means the path back to 2% inflation is likely to be slow and risks remain.”

There are other upside risks to inflation: “We are also seeing some volatility in global oil and transportation costs related to wars in Europe and the Middle East and attacks of ships in the Red Sea. Needless to say, monetary policy has no control over these global events, but they could add volatility to inflation in Canada. If this happens, our monetary policy focus will be on whether increases in energy or transportation costs are feeding through more broadly to inflation in other goods and services.”

The BoC needs to see more evidence that inflation is headed back to its target before it can ease: “We need to give monetary policy more time to ease the remaining price pressures in these goods and services.” “Our decision to hold our policy rate at 5% reflected Governing Council’s view that more time is needed to let monetary policy do its work to relieve underlying price pressures. With continued evidence that monetary policy is working, Governing Council’s discussion about future policy is shifting from whether monetary policy is restrictive enough to how long to maintain the current restrictive stance. We want to see inflationary pressures continue to ease and clear downward momentum in underlying inflation.”

Bottom Line:

The Governor spent much of his speech affirming that monetary policy works to control inflation and stabilize financial markets when needed. Curiously, he left out the role of central banks as potential culprits for over-stimulating the economy in the run-up to the events mentioned, although he did acknowledge that in hindsight, he could have begun withdrawing stimulus sooner after the COVID recession. But the past is the past, so where do we go from here? Mr. Macklem says that restrictive monetary policy has certainly helped bring down overall inflation, but its impact on housing costs has been stymied by a structural shortage of housing, something monetary policy cannot fix. This is something the Bank of Canada (BoC) has only recently begun to acknowledge in speeches (see T. Gravelle on Dec. 7) and its January Monetary Policy Report. So much so that the Bank of Canada expects shelter inflation to account for about 50% of total inflation over the next two years (almost double its 26% weight in the CPI basket) and to "act as a material headwind against the return of inflation to the 2% target".  Acknowledging the problem is one thing, but whether the BoC will be willing to accommodate a source of inflation over which it has little control remains to be seen. If the BoC remains reluctant to see through shelter inflation for too long, there is a risk that monetary policy will remain overly restrictive in the coming months, causing undue pain to the economy and exacerbate housing supply imbalances against a backdrop of surging population (we note that residential building permits collapsed in most urban areas in December). This partly explains why we continue to expect an economic contraction in 2024 and more aggressive easing of monetary policy than is currently assumed by markets.

Stéfane Marion andJocelyn Paquet