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Thursday, February 15th, 2024

Crisis underscored risk from credit excesses: Bank of Canada

Mark Carney

Mark Carney, Governor of the Bank of Canada, holds a press conference to discuss the contents of the Monetary Policy Report at the National Press Theatre in Ottawa on Wednesday, October 26, 2011. Sean Kilpatrick/THE CANADIAN PRESS

The 2008-09 crisis and its aftermath have underscored the unique risks that credit-fuelled excesses pose to economies, forcing the Bank of Canada to pay closer attention to financial stability and to be flexible as it pursues its No. 1 goal of keeping inflation tame and reliable, Mark Carney and his policy team said Wednesday.

A day after the Harper government confirmed that the Bank of Canada will continue to focus squarely on achieving annual price gains of about 2 per cent for another five years, policy makers released a background document detailing situations in which they might take longer than usual to reach their inflation target to respond to an economic shock or a building imbalance in the financial system.

While the central bank is still mandated to achieve its inflation target above all else, policy makers essentially said the success of that framework and the lessons of the recent crisis mean there may be cases where monetary policy can be used to complement efforts by regulators and supervisors to keep the financial system stable. There is no consensus on how to do this, in part because dangerous financial bubbles are hard to identify before they burst, but there is a growing sense that pure inflation-targeting is insufficient for the post-crisis economic realities.

“Economic stability and financial stability are inextricably linked, and pursuing the first without due regard for the second risks achieving neither,” Mr. Carney and his officials said in the document. “A framework anchored on a solid and credible inflation target provides the flexibility for monetary policy to play an occasional role in supporting financial stability.”

Policy makers said they drew three main lessons from the crisis. First, financial imbalances linked to credit booms that affect asset prices — like housing, for example — pose the greatest risk to the economy because of the “powerful deleveraging process” that occurs when they unwind. Second, good economic times all too often cause the imbalances to build, due to complacency and a better climate for risk-taking. And third, the financial system in Canada and around the world is so interconnected and tightly linked that bad behaviour by one bank can affect many others and ripple through the economy.

The central bank maintains that the first “line of defence” against financial instability is responsible behaviour by consumers and lenders, and that the second is a regulatory and supervisory approach — both in Canada and abroad — with a “greater focus on system-wide vulnerabilities.” Still, even though monetary policy is too blunt an instrument to try and address a localized problem affecting one region or sector, such as a housing bubble in one city, it is a “potentially valuable tool in addressing imbalances that may eventually have economy-wide implications,” the bank said.

“Monetary policy can contribute to financial stability directly in some circumstances by complementing macroprudential policy, particularly when broad-based imbalances are building or unwinding,” the bank said.

Mr. Carney has argued for months that his mandate affords him leeway to lean against economic shocks or dangerous buildups of credit by taking longer than usual to bring inflation to target. Indeed, the bank’s 2006-2011 mandate already allowed that in some situations, taking longer than the typical six to eight quarters to return inflation to 2 per cent “might be considered.”

Still, at the time that the last agreement was being negotiated few could have imagined how often the central bank might need to take advantage of that flexibility.

In recent months, Mr. Carney has touted his flexibility as an important tool for keeping Canada’s export-dependent economy fortified against headwinds from abroad. He has left his benchmark interest rate at 1 per cent since the fall of 2010, even during the summer months in the face of hotter-than-expected inflation readings and much criticism from so-called inflation hawks.

Wednesday’s background document expanded on this theme, arguing that the nature and persistence of shocks “buffeting the economy” dictates whether the central bank takes longer than normal to bring inflation to target — something it has already done on several occasions. For instance, to keep the economy stable amid a big spike in oil prices or a severe global slowdown, or to counter the effects of either a buildup in credit or a widespread effort by households and businesses to trim their debts.

“The Bank’s scope to exercise appropriate flexibility with respect to its inflation-targeting horizon is founded on the credibility built up through its demonstrated success in achieving its inflation target,” the bank said, noting that inflation has averaged 2 per cent since targets were first introduced in 1991. “This flexibility has been an inherent feature of the monetary policy framework in Canada and all other countries that practice inflation targeting.”

Although Canada’s inflation-targeting approach has been viewed as highly successful, researchers at the central bank have been studying ways it could be tweaked or improved. The bank had devoted much effort into exploring whether to eventually adopt a new system that would target a certain level in the consumer price index, rather than the annual rate of change, or whether to cut the target to as low as 1 per cent.

While policy makers will continue that research, neither change was adopted.

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