What monetary policy can and cannot do
If the economy is on a lower path and there’s upward pressure on inflation, what’s the response from monetary policy and the Bank of Canada?
What the Bank can do is help the economy adjust. With inflation now back around the 2% target, we are better positioned to contribute to economic stability. However, with a single instrument—our policy interest rate—we can’t lean against weaker output and higher inflation at the same time. As we consider our monetary policy response, we will need to carefully assess the downward pressure on inflation from weakness in the economy and weigh that against the upward pressure on inflation from higher import prices and supply chain disruptions.
Unlike the pandemic, if tariffs persist there will be no economic bounce-back. Long-lasting tariffs mean lower potential output because our economy works less efficiently. Monetary policy cannot restore the lost supply. At most, it can smooth the decline in demand.
The sharp fall in exports and investment when tariffs are imposed, combined with weaker consumption, means that initially demand would fall more than potential output, creating excess supply in the economy. Provided the inflationary impact of tariffs is not too big, monetary policy can help smooth the adjustment by supporting demand so it doesn’t weaken too much more than supply. But how much support monetary policy can provide is constrained by the need to control inflation.
The initial impact of tariffs is a one-time rise in the level of consumer prices. Monetary policy cannot change that. What monetary policy can—and must—do is ensure that higher prices do not become ongoing inflation. This means making sure that households and businesses continue to expect inflation to remain well anchored on the 2% target. Simply put, monetary policy needs to ensure the increase in inflation is temporary.
Strengthening Canada’s economic union
I hope—we all hope—Canada can continue open trade with the United States. A trusted open trade relationship benefits both countries. But if we are faced with a prolonged trade conflict, the only way to offset this negative structural change is with a positive structural change.
Structural policies are appropriately the responsibility of elected governments and parliaments—not the Bank of Canada. So I will tread lightly here.
The Bank has previously highlighted Canada’s productivity challenge. And it’s good to see more focus by federal and provincial governments on structural reforms to increase productivity and investment by strengthening our economic union.
Removing rules that restrict interprovincial trade and harmonizing or mutually recognizing provincial regulations could provide some offset to increased trade friction with the United States. Provinces could also make it easier for workers to move within Canada by mutually recognizing different labour accreditations. There is also scope for all levels of government to reduce the timelines and uncertainty related to regulatory approvals. And better east-west transportation links would make trade within Canada less expensive—and help get Canadian products to overseas markets.
Again, it is not for the Bank of Canada to prescribe these policies or investments. But higher productivity means higher potential output and more capacity for growth without inflation. As Canada confronts the reality of increased trade friction with the United States, a concerted focus on productivity has rarely been more important.
Renewing our monetary policy framework
In some ways, the US tariff threat is part of a broader global economic shift. The structural tailwinds of peace, globalization and demographics that helped keep inflation low are turning into headwinds—and the world looks increasingly shock prone. Higher long-term interest rates, elevated sovereign debt and slower economic growth have made the global economy more vulnerable. Compounding these vulnerabilities are war, rising trade protectionism and economic fragmentation. Canada also has a structural supply challenge in its housing market. For years, the supply of housing has not kept up with demand, and housing affordability has deteriorated.
These shifts all have implications for inflation. They may put more upward pressure on prices, and a more shock-prone world means more volatility in inflation. And that brings me to my original topic: the Bank’s flexible inflation-targeting framework.
Since 1995, the 2% target has been jointly agreed with the Government of Canada. This gives it political legitimacy and gives the Bank the operational independence to conduct monetary policy.
For 25 years leading up to the pandemic, inflation was low and stable. But the pandemic tested the framework like never before. We faced huge shocks to both demand and supply, a deep recession and a rapid rebound. As the economy reopened, inflation rose sharply, hitting 8%. Guided by the framework, the Bank raised the policy rate forcefully to bring inflation down. Since last summer, inflation has been close to 2%, and we’ve cut our policy rate to keep it there. In short, the framework was tested—and it proved resilient.
The measure of the framework’s success is not only whether inflation is close to 2%. It’s also how the framework performs in the face of shocks, especially big ones.
The next renewal of the framework is set for 2026, and the review begins now. Our focus in this review will be how we can improve the framework and its implementation to best address structural changes. We will consider several questions.
With more supply shocks, do we need a richer playbook for monetary policy? The usual response to supply shocks is to look through their temporary impact on inflation. But we saw in the pandemic that supply shocks can be persistent, and they can accumulate. The best response will depend on the situation.
In a world with more volatility, how should we measure underlying inflation? No single measure of core inflation works for all circumstances. What measures are most robust in a shock-prone world? Should we focus on two or three preferred measures, or is a broader approach better?
We also want to consider the interaction of monetary policy and housing. Housing affordability is a major concern for Canadians, and rising housing costs feed inflation. But monetary policy cannot directly increase housing supply—that’s an issue for elected governments at all levels. Still, we must consider how monetary policy affects housing demand and supply and how the imbalance between them feeds into inflation in shelter prices.
The question of housing market imbalances also matters for the measurement of underlying inflation. Does persistently high inflation in shelter prices distort our measures of core inflation?
Finally, each time we’ve reviewed our framework we’ve asked about the inflation target itself. In our five reviews since 1995, we’ve considered whether 2% is the right target and we’ve weighed alternatives, including price-level targeting and nominal GDP targeting, among others. Each time, we’ve concluded that 2% inflation is the right target. Canadians have told us they don’t want higher inflation. They have also told us that the 2% target is well known and well understood. That has helped anchor inflation expectations through thick and thin, including through the pandemic crisis. With trade conflict on our doorstep, we need to focus our resources on the most pressing and important issues for our framework review. In my view, now is not the time to question the anchor that has proven so effective in achieving price stability.
Conclusion
We have covered a lot of ground, and it’s time for me to conclude.
Canada’s economy is on a better footing. Inflation has returned to target, interest rates have come down substantially, and household spending has strengthened. But a new crisis is on the horizon. If US tariffs play out as threatened, the economic impact would be severe. A protracted trade conflict would sharply reduce exports and investment. It will cost jobs and boost inflation in the next few years and lower our standard of living in the long run. The uncertainty alone is already causing harm.
Central banks can do little to mitigate the damage caused by a trade war. Our role will be to balance the upside risks to inflation from higher costs with the downside risks from weaker demand. Our focus will be to help smooth the painful adjustment to a lower path for the economy while preventing price increases from becoming higher ongoing inflation.
The inflation-targeting framework has proven both flexible and durable. Its review every five years is an opportunity to reflect on what’s working well and what could be improved. The framework proved itself time and again, and the bar for change is high.
But the world economy is shifting. At the Bank of Canada, we are committed to ensuring we are as prepared as possible for the changes to come.
Thank you.
I would like to thank Daniel de Munnik, Mikael Khan, Oleksiy Kryvtsov and Stephen Murchison for their help in preparing this speech.
