The Bank of Canada lowered its policy rate to 4.75 percent on June 5, having increased confidence that with an unemployment rate of 6.1 percent, inflation will continue to move closer to the 2 percent target. –Financial Times, June 5, 2024
What is the Bank of Canada’s policy target?
The Bank of Canada’s policy aims to keep the 12-month rate of change of the total CPI close to 2 percent and in a target range of 1 to 3 percent.
Has the Bank of Canada achieved its inflation target?
Figure 1 shows the 12-month rate of change of the total CPI and its 1 to 3 percent range for the past three years.
The Bank of Canada has not achieved its target. Canadian inflation exceeded the target range between April 2021 and June 2023, and again in the second half of 2023. Inflation increased quickly to a peak of 8 percent in June 2022, and then fell quickly until June 2023. In 2024, inflation fell slowly and returned to its target range.
What is the Bank of Canada’s policy interest rate, how has it changed over the past two years, and has the Bank conquered inflation?
The Bank of Canada’s policy interest rate is a target for the overnight rate on loans that banks make to each other.
Figure 2 shows the level of this interest rate since July 2020.
The Bank set the overnight rate at a record low of 0.25 percent during the covid pandemic and started to raise it in March 2022, when inflation was running at 6.7 percent and had been above target for almost a year. Ten rate rises took the overnight rate to 5 percent by July 2023, where it remained until June 2024.
Figure 3 compares the data in Figures 1 and 2. It shows that the rising overnight rate lagged almost a year behind rising inflation, and falling inflation did not return to and remain in the target range until the overnight rate reached 5 percent.
Although the inflation rate has returned to its target range, it remains above the 2 percent midpoint of the target range. So, in June 2024, the Bank of Canada had not yet conquered inflation.
Is a 6.1 percent unemployment rate high?
Figure 4 shows Canada’s unemployment rate since July 2020.
An unemployment rate of 6.1 percent is close to average and close to the natural unemployment rate.
Unemployment was high during the covid pandemic and drifted downward as the economy recovered and reached a low of 5 percent in July 2022. Since then, unemployment has risen slightly as the rising interest rate slowed the economy.
Does Canada face a Phillips curve tradeoff between inflation and unemployment?
Canada does face a Phillips curve tradeoff between inflation and unemployment, but as Figure 5 shows it is a shifting tradeoff.
In the long run, unemployment is at the natural unemployment rate, which we’ll assume to be 6 percent, and the economy is on its long-run Phillips curve LRPC.
The short-run Phillips curve, SRPC, depends on the expected inflation rate.
In 2020, when inflation was on target, the expected inflation rate was 2 percent and the SRPC was SRPC0.
During 2021 and 2022, as inflation increased, the expected inflation rate increased to 7 percent and the SRPC shifted upward to SRPC1.
As the inflation rate fell in 2023 and 2024, the expected inflation rate fell to 3 percent and the SRPC shifted downward to SRPC2.
Why does the Bank of Canada have increased confidence that inflation is moving closer to the 2 percent target?
The Bank of Canada has increased confidence that inflation is moving closer to the 2 percent target for two reasons. First, its interest rate increases operate to lower inflation with a time lag and the 11 months with the interest rate at 5 percent has not finished placing further downward pressure on inflation. Second, at 6.1 percent, the unemployment rate is at or above the natural unemployment rate, so no tightness in the labor market is placing upward pressure on inflation.
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