Timothy Lane: Expecting the unexpected - central bank decision making in turbulent times
Central bank: boc | Type: speech | Date: 2022-02-16

Remarks by Tim othy Lane Deputy Governor School of Public Policy, University of Calgary February 16, 2022 Calgary, ABProtected B

## Expecting the unexpected: Central bank decision making in turbulent times

## IntroductionGood morning.

I'm happy to be here with you today, albeit

virtually.For two years now, we have been living through a period of history like no other.

Successive waves of COVID-19 have claimed the lives and livelihoods

of many Canadians.

The economic impacts have also been extraordinary.The Canadian economy has now recovered substantially.

Economic activity is above its pre-pandemic level and employment is near its maximum sustainable

level.

But the economy is still not back to normal.This has been a time of tremendous uncertainty for both economic policy-makers and those in the fields of health and science.

So it seems fitting to begin our discussion

with a thought from renowned Canadian physician William Osler, who is often described as the father of modern medicine.

Over a century ago, Dr. Osler transformed the way medicine was taught by combining classroom study with bedside

experience.He said that medicine is a science of uncertainty and an art of probability.

That could apply equally to economic policy, and never more so than now.Indeed, Osler's emphasis on the need to combine analysis

with experience is highly relevant to the uncertain world of economics.Today I would like to talk about

how the Bank of Canada makes decisions

in turbulent times.

I will use the pandemic as a case study.

In doing so, I will draw back the curtain on the Bank's deliberations

during various stages of the crisis and how that thinking shaped our policy actions and our communications with Canadians.

Finally, I'll speakI would like to thank Don Coletti for his help in preparing this speech.more generally about how we are adapting

our own practices at the Bank to better anticipate and respond to uncertainty in the future.

## Looking back over the past two yearsLet me set the stage by briefly reviewing what has happened

to the Canadian economy over the past two years.In early 2020, the pandemic triggered

sudden and severe economic contractions around the world.

In Canada, gross domestic product (GDP) declined by about 15% and about three million Canadians

lost their jobs.Inflation also declined sharply, from around 2% to near zero.

This was largely due to the collapse in world oil prices.

We also saw declines in the prices of hard-to-distance services such as air travel-for the few still flying.But if the economic contraction was unprecedented,

so was the recovery that followed.As we can see in Chart 1 , GDP bounced back sharply in the second half of 2020 when the initial

surge

in the number of COVID-19 cases stabilized.

More recently, GDP actually passed

its pre-pandemic level.Chart 1: Real gross domestic product in CanadaQuarterly data,

chained 2012 dollars,

seasonally adjusted

at an annual

rateNote: Dashed line indicates projected level from the January 2022 Monetary Policy Report .Sources: Statistics Canada and Bank of Canada projectionssLast data plotted: 2022Q4And, as this next chart shows, the recovery in employment was also impressive ( Chart 2 ).

## Chart 2: Employment and unemployment in CanadaMonthly data, seasonally adjusted- a.

Total employment in CanadaSources: Statistics CanadaLast observation: January 2022Robust job gains have brought employment back to where it was before the pandemic.

A range of measures shows that with this recovery, overall slack in the Canadian economy has been fully absorbed.

Indeed,

we are seeing increasing

signs of scarcity of labour and of some goods. 1Meanwhile, the next chart shows that inflation not only recovered from near zero but is now well above the Bank's 2% target ( Chart 3 , panel a).1 For more details, see Bank of Canada, 'Box 3: Economic slack in the fourth quarter of 2021,' Monetary Policy Report (January 2022).

## Chart 3: Consumer price index and inflation in CanadaMonthly dataSources: Statistics Canada and Bank of Canada calculationsLast observation: December 2021This surge in inflation has been more persistent

than anticipated.

Part of it reflects a catch-up in prices after inflation dropped in 2020 ( Chart 3 , panel b).

It also reflects the impacts of both supply constraints

and strong demand in global

markets-especially for goods.

We now expect that inflation will remain close to 5% through the first half of this year.

## The initial policy responseSo now that we've talked about

our journey over the last two years, let's

turn our attention

to the policy response

in those early days of the crisis.

The sheer scale and complexity of this pandemic was beyond what anyone anticipated.

How did the Bank navigate its course?Once the virus spread across the world and the first lockdowns were implemented, we clearly understood

that the economic and financial impacts would be serious.

Just how serious

was still quite uncertain.

But we knew that the situation

called for extremely aggressive

policy responses,

right from the start.

Our thinking was that it was better to do too much up front to strongly support the recovery than to play catch-up later.When the pandemic first hit, the top priority was to support

Canadian households

and businesses.

In addition

to helping

those

most directly affected, our goal was to prevent second-round

effects on other sectors of the economy-notably the impacts that can occur when those who have lost income cut back their spending.

We were also worried about businesses

delaying investments.A second problem we needed

to tackle right away was the breakdown of financial markets.

In an atmosphere

of panic, asset values plummeted and we saw a generalized dash for cash.

Market liquidity

suddenly evaporated-in

other words, sellers

had difficulty finding buyers, even for safe assets such as government bonds.

This dynamic threatened

to block the flow of credit for households

and businesses

just when they needed it most.The Bank responded

swiftly and aggressively to restore calm to financial markets.

We provided liquidity

to the financial system through

several channels, including

repurchase agreements and direct asset purchases

in a range of financial markets.

These actions, alongside

similar measures taken by central banks in other countries,

quickly restored market functioning worldwide.It was clear that the federal government's

fiscal policy would need to take primary responsibility

for supporting

households

and businesses,

because it could focus that support to manage the uneven impacts of the pandemic.

Many Canadians

who had the option of working remotely stayed employed.

Meanwhile, many in hard-to-distance services-disproportionately

staffed with lower-wage workers, racialized

Canadians, and women-lost their jobs.

The government quickly responded

with transfers to support incomes for affected households

and to keep businesses

afloat.The Bank acted forcefully with monetary policy as well.

During March 2020, we cut our policy interest

rate three times, from 1.75% to 0.25%.

In July, we pledged to keep the rate at this level 'until economic slack is absorbed.' In October we complemented our conditional

forward guidance with a forecast-but not a commitment-of when we thought that condition

would be met.

The decision not to commit to a specific date reflected the great uncertainty around the outlook.We also committed to continue our purchases of government bonds until the recovery was well underway.

These purchases were made initially to restore market functioning but then served as another tool of monetary policy: quantitative

easing.

This tool was implemented to keep borrowing costs low across the yield curve.

The overriding goal was to support the economy through this economic contraction and bring inflation back to the Bank's 2% target.

That's because, if left unchecked, the pandemic forces at work on the economy in those early days could drive inflation persistently

below zero, starting a deflationary spiral.These policies combined a bold response

with a clear exit strategy.

Given the heightened

uncertainty, our exit from emergency measures had to be based on outcomes, not on a fixed calendar.

That is, we would:- provide liquidity

until market functioning was restored- continue quantitative

easing until the recovery was well underway- maintain our forward guidance until slack was absorbedWe provided clarity about the conditions

for exit while recognizing

that the timing must depend on how the situation

unfolded.

As events played out, we updated Canadians

on when the conditions

were likely to be satisfied.

Markets could also update their own views as data came in.

## How did our views and policy response evolve?The recession Canada faced was nothing like a textbook case and there was exceptional uncertainty about how it would play out.

In fact, in our April 2020 Monetary Policy Report, we did not publish

our usual forecast but instead

presented

a range of possible

outcomes as we see here ( Chart 4 ).Chart 4: Real GDP, projected range versus actual Quarterly data,

chained 2012 dollars,

seasonally adjusted

at an annual

rate* Projected range from the Bank of Canada's April 2020 Monetary Policy ReportStatistics Canada and Bank of Canada projectionsLast data plotted: 2022Q4These possible

outcomes reflected two distinct dynamics.

Some economic activity and employment would return to normal levels as soon as the pandemic subsided

and lockdowns were lifted-similar to what often happens

following a natural disaster.

Other economic activity would take longer to come back.

Indeed, in the spring of 2020 economists around the world debated about whether the recovery would be V-shaped or L-shaped.

The Bank's view was that each of these dynamics would likely play out in turn, resulting

in a two-phased

recovery: first reopening

and then recuperation.Why did we expect full recuperation

to take longer?

It was partly because of our experience with the global

financial crisis of 2008-09.

The long, drawn-out recovery that followed that crisis reflected a large and prolonged

rise in unemployment and massive damage to balance sheets.

As a result, the global economy took 10 years to recover to its pre-crisis

trend.Labour markets can be damaged by lengthy recessions.

Unemployment can have persistent

effects on people's

skills and their ability to re-enter the workforce.

Because the pandemic began with such a huge increase in unemployment and so much uncertainty around how long

the pandemic would last, this concern was front of mind.

The unevenness

of job losses

caused by the pandemic also suggested

that inequality could widen, which itself has negative economic consequences.In all, we saw powerful downdrafts on the economy in those early months-reflected in our expectation that it would take until 2023 for slack to be absorbed.

The same view was evident in our projection for inflation at the time.We can see in Chart 5 that our earlier projection showed inflation creeping up to our 2% target over three years.Chart 5: Consumer price index inflation, projected versus actualYear-over-year percentage change, quarterly data, not seasonally adjusted* Projected CPI inflation from the Bank of Canada's July 2020 Monetary Policy Report Sources: Statistics Canada and Bank of Canada projectionsLast data plotted: 2022Q4Needless

to say, this is not exactly how things turned out.

The economy's path of recovery has followed the upper edge of the range we had contemplated.

Employment recovered more quickly than expected.

And inflation persistently

ran much higher than anticipated

and is now well above our target.But why?

It really comes down to supply and demand.In the early months of 2020, we realized

that the pandemic would have adverse effects on both demand and supply.On the demand side, we expected households

to rein in their spending

while job losses translated

into lower household

incomes and weaker confidence.

The experience

from the global financial crisis also suggested

that financial institutions

could be less willing tolend amid the heightened

uncertainty.

This experience also suggested

that it could take a long time for consumer confidence and spending

to recover.On the supply side, we anticipated

a temporary loss of supply or productive capacity.

Some production

facilities were locked down and

for others, the extra time and effort needed to comply with health requirements

could weigh on productivity.

But our projections

assumed that the effects on supply would be less severe and would ease fairly quickly as restrictions

were lifted.

Since demand was expected to take longer to recover than supply, that meant that persistent

economic slack would continue to put downward pressure on inflation.There are several ways in which supply and demand behaved differently than we expected.

For one thing, vaccines were developed

and deployed in record time, a little more than a year after the pandemic first began and one year sooner than we originally assumed.In addition,

we underestimated

the ability of businesses

and workers to adapt to the pandemic and learn how to work around it in innovative ways.

This period

is marked by accelerated growth in all aspects of the digital

economy. 2These are important reasons

why both demand and supply-and thus GDP-recovered so quickly.The forcefulness of our economic policy response

also helped us avoid many of the negative effects on demand that we had been concerned about.

The scale of fiscal transfers meant that the disposable

income of Canadian households

actually increased during the pandemic and business

bankruptcies declined-both

unheard of during a recession.

Households

were able to increase savings and pay down non-mortgage debts.

And the financial system, far from being a source of drag on the economy, became a sturdy support.A related factor that was initially underestimated

was the shift of demand both in Canada and abroad.

Households

that could not spend on services like restaurant

meals and vacations shifted their spending

to goods that were available,

such as sports equipment, appliances

and electronics.

This shift in demand toward goods increasingly ran up against global supply constraints

during 2021, helping

to push inflation higher than expected. 3Production disruptions

proved to be a more troublesome

force than originally anticipated.

Because production

is highly interconnected

across countries, disruptions

in one country quickly resulted in supply shortages

in others.

Specific chokepoints surfaced-such as the supply of semiconductors and shipping

capacity-but the2 See T.

Lane, 'The Digital Transformation and Canada's Economic Resilience' (speech delivered virtually to Advocis Western Canada Chapters, Edmonton, Vancouver and Winnipeg, June 10, 2021). 3 See T.

Gravelle, 'Economic Progress Report: A Recovery Unlike Any Other' (speech delivered virtually to the Surrey Board of Trade, Surrey December 9, 2021).disruptions

became increasingly

persistent

and widespread.

Even now, it's unclear how long it will take to resolve these issues.Furthermore, Canadian firms have increasingly faced their own capacity constraints.

A record number of respondents

to our December Business

Outlook Survey said they would have difficulty meeting increased demand.

This partly reflects shortages

of essential

imported components.

But it also

speaks to the shortages

of workersparticularly those with specialized

skills-caused

by tightening

labour markets.Combining all these factors, demand was more robust and supply more constrained than we expected-resulting

in stronger-than-expected

economic growth and persistently

higher

inflation.Throughout

all this,

we adjusted

monetary policy as the recovery advanced.

We scaled back our quantitative

easing, ending it in October 2021, and entered the reinvestment phase.

We now purchase bonds only to keep our overall holdings

stable as bonds mature.And while our exceptional forward guidance remained in place until a few weeks ago, we regularly updated our view of when the necessary conditions to raise interest rates would be met.

On January 26, 2022, we removed forward guidance altogether,

based on our assessment

that slack in the economy had been absorbed.

We expect that interest rates will need to increase, with the timing and pace of those increases guided by the Bank's commitment to achieving our 2% inflation target.

We indicated that, once we begin to raise the policy rate, we will consider exiting the reinvestment phase and reducing the size of our balance sheet by allowing maturing bonds to roll off.Many of the factors that influenced our policy deliberations

throughout

the pandemic have come into sharper focus as we gain experience with a recession that is unlike any other.

This illustrates

why it's so important to have decision-making

processes that can adapt to new information, analysis and experience-which is what I'd like to talk about next.

## Our adaptable analytical and decision-making processesMuch of what I have been discussing

is not captured well by our standard economic models.

Indeed, over time, we have adjusted

our models so that they could relate even more to the unique circumstances of the COVID-19 pandemic.Bank of Canada economists have increasingly

been drawing on novel sources of data to get a sense of what is happening

on the ground.

Real-time data have been especially valuable because the situation

has been changing so rapidly.

For example, online restaurant

reservations

and data from Interac on spending

gave a more timely readout of consumer behaviour.

Such data became particularly important as the pandemic drove many more customers to do their shopping

and other activities online.

Similarly, online job postings

complemented other indicators

we use to assess

labour market conditions.

During the pandemic, epidemiological

data have also been essential-andwe have been talking regularly with epidemiologists

and public health officials to interpret these data.The uneven economic impacts of the pandemic further underscore the importance of looking at data broken down in various ways.

This has allowed us to better assess

how situations

were affecting different groups of people in unequal

ways and how this might affect economic outcomes on a larger scale.

For example, we have increasingly

been focusing on a wider range of labour market indicators

and publishing

them in our quarterly Monetary Policy Report and on our website.To make better use of all these data, our economists

have been taking innovative approaches,

including working with big data and advanced analytics.

These new analytical tools and information sources

have allowed us to fill important gaps in our understanding

of what was happening

in all parts of the economy.Events such as the pandemic also show the value of talking with and listening

to Canadians.

To quote Dr. William Osler again: Listen to your patient-he

is telling

you the diagnosis.

For many years, we have carried out our quarterly

Business

Outlook Survey and maintained

a regular dialogue

with business

leaders.

This was instrumental, for example, to understanding

the nature and extent of supply constraints in Canada.

We now also conduct the Canadian Survey of Consumer Expectations four times a year which, amongst other things, helps us evaluate the extent to which consumer inflation expectations remain anchored.

We are also pursuing

a deliberate

strategy of broadening

the set of stakeholders

we consult to sharpen our insights

into the economy.More generally,

turbulent times call for openness

to new facts and ideas and agility in decision making.

Uncertainty may require a cautious and gradual approach when entering uncharted territory-but as the pandemic has illustrated,

there are times when policy-makers must act boldly.

Any policy involves risk, but inaction is often riskier.

It's important to take those risks, but it's equally important to fully understand

them and be transparent

in communicating their nature. 4When coming to a policy decision, the Bank looks at several risks and assesses

their relative importance.

Many risks are two-sided, but we may be more concerned about one side than the other.

This has been particularly true during the pandemic.

Given the magnitude of the impact at the beginning

of the crisis, our concern about of the downside

risks to the economy led us to deliver an aggressive

monetary policy stimulus.

As the situation

evolved, however, our policy action shifted along with the balance of risks.

Currently, with inflation well above our target, we are increasingly focused on countering the upside

risks.At different stages in the pandemic we have changed our outlook and our policy stance to respond to the uncertain and fast-changing situation.

What remained constant,4 See S.

Kozicki and J.

Vardy, 'Communicating Uncertainty in Monetary Policy,' Bank of Canada Staff Discussion Paper No. 2017-14 (November 2017).however, was our commitment to explaining

the basis for our projections and our decisions.

We have been clear that

we can't be certain about many things.

We have also been candid in describing

the risks involved at any given moment.

Although we cannot eliminate uncertainty, we can provide as much clarity as possible

about the Bank's actions and decision-making

processes.

This was clearly reflected in the conditions

we included in our forward guidance throughout

the pandemic.

And it was in that spirit

that we announced our decision in January, making it clear that with slack now absorbed,

interest rates will need to be on a rising path to bring inflation sustainably

back to the 2% target.

## ConclusionThe pandemic has brought much that was unexpected.

We have drawn on our analysis and experience to reach a clearer understanding

of the forces at work, but we must anticipate the possibility

of more surprises

before this

chapter is closed.While we now expect supply disruptions

to ease and inflation to come down quickly in the second half of this year, we are alert to the risk that inflation may again prove more persistent.

We will be nimble-and if necessary, forceful-in using our monetary policy tools to address whatever situation

arises, as we have done throughout

these turbulent times.We know that Canadians

count on us to make the right decisions in the face of uncertainty and to navigate relentless

change.

And we will always work hard to be worthy of that confidence.Thank you.