Sheryl Kennedy: Dealing with uncertainty in the conduct of monetary policy
Remarks by Ms Sheryl Kennedy, Deputy Governor of the Bank of Canada, to the Montréal CFA
Society, Montréal, 12 April 2007.
* * *
Bonjour. It's great to be here to give you my best wishes as you begin preparations for the CFA
Institute's sixtieth anniversary celebrations.
I want to speak to you today about dealing with uncertainty. I know you need to deal with uncertainty
in your work as CFA charter holders. Uncertainty is also a fact of life for central bankers. To quote
Alan Greenspan, "uncertainty is not just an important feature of the monetary policy landscape; it is
the defining characteristic of that landscape."1
In my remarks today, I'll discuss the uncertainty inherent in monetary policy-making, and explain the
strategies we at the Bank of Canada use to deal with that uncertainty. I should emphasize that the
uncertainty I'll be speaking about relates to the models, indicators, and data we use to conduct
monetary policy, not to what we call "risks" to the economic outlook - that is, possible outcomes
around our "base-case" projection. To make my remarks concrete, I'll refer to how we estimate the
potential output of the economy. But first, I think it would be useful to provide a brief sketch of what
monetary policy aims to achieve.
What monetary policy aims to achieve
The main goal of monetary policy is to help the country achieve strong, sustainable economic
performance, and, in doing so, to contribute to rising living standards for Canadians. Experience has
shown that the best way for a central bank to meet this goal, given the instruments at its disposal, is by
keeping inflation low and stable. Low and stable inflation increases confidence in the future value of
money, and allows for clear price signals. These benefits, in turn, help consumers, savers, and
investors to make sounder economic decisions. The Bank of Canada has a clear inflation objective,
and that is to keep the annual increase in the consumer price index as close as possible to 2 per cent.
That objective, together with our transparent framework for how we go about achieving it, helps to
anchor inflation expectations, and adds a significant amount of certainty to the economic and financial
environment.
An important element of controlling inflation and promoting sustainable growth is keeping the economy
operating in line with its production capacity. For the central bank, this means getting a good reading
potential output.
on this capacity, which we call the economy's Potential output is not directly
measurable. And it changes over time with changes in productivity, the capital stock, and the
composition of the labour force. So, as we try to keep demand in balance with the economy's capacity
to produce at a sustainable pace, the Bank is dealing with variables that are both hard to measure and
evolving.
When aggregate demand pushes the economy beyond its capacity limits, thus threatening to raise
inflation above target, the Bank will - all things being equal - raise its policy interest rate. And, in
symmetric fashion, when unused capacity puts downward pressure on inflation, threatening to push it
below the target, the Bank will - all things being equal - lower the policy rate.
Of course, there's a lot packed into that phrase, "all things being equal."
One complication involves persistent movements in relative prices, which can affect inflation. For
instance, a trend reduction in the prices of imported consumer goods puts direct downward pressure
on inflation, since the prices of these goods are included in the consumer price index. This, in turn,
provides scope for the economy to operate at a higher level than would otherwise be the case.
A second complication is the time lag between a policy action and its effects. While a change in the
policy rate can begin to affect output fairly quickly, it typically takes 18 to 24 months for the full effects
to be felt on inflation, and that means that the Bank has to be forward looking and base its decisions
on projections of future pressures on inflation. It also means that a large part of what we're doing as
we deliberate on the appropriate interest rate setting is trying to look through the "noise" of the
moment to get a sense of the underlying trends. We need to look through short-term, temporary
volatility that will have disappeared by the time our actions have an effect on inflation.
A third and related complication arises when a shock hits the economy. Beyond the initial element of
surprise, there can be uncertainty about the magnitude of the effects of the shock, about how the
economy will be affected, and about how long the shock will last.
Try to imagine steering a ship. The ship's captain needs to regularly ascertain the ship's current
location by means of various instruments and readings, scrutinize the charts to see whether there are
any obstacles ahead, and then apply judgment to determine the best course to arrive safely at the
destination. In like fashion, a central bank cannot directly see everything ahead, and so it must rely on
models, data, and indicators, and then apply judgment to determine the best course for meeting the
monetary policy objective. And the economy, like a large ship, takes time to respond to a change in
course.
But unlike the precise instruments and readings available to the captain, our models, data, and
indicators provide only approximate information. Models, data, and indicators are invaluable in
informing monetary policy, but a good deal of uncertainty is inherent in them. By definition, models are
simplifications of reality, and never entirely reflect the complexity of a dynamic economy. Our main
indicators are derived from data, but the data we use are often subject to a good deal of revision. And
for certain variables that are fundamental to conducting monetary policy - potential output is a good
example - there are no direct measures at all. Our destination, however, remains clear: achieving the
2 per cent inflation target.
So, how do we at the Bank of Canada deal with the uncertainty inherent in the models, indicators, and
data we use when conducting monetary policy?2
Responding to uncertainty
As CFA charter holders, you'll be aware of Peter Bernstein's writings on risk. His advice is to treat
uncertainty as a "friend" - "with care, consideration, and attention to consequences."3 And that's the
bottom line for the Bank of Canada, too. We treat uncertainty about our models and data - and the
risks to the outlook as well - with care, consideration, and attention to consequences.
Again, consider the captain of a ship. Like the captain, we need to know first where we are now. That
means knowing, among other factors affecting inflation, the current level of output relative to potential.
To do this, we first run our models for potential output with the most recent data and revisions, which
brings us up to date on recent history. But we also look at a range of other data and indicators before
coming up with a judgment about our current situation. Then we have to determine what lies ahead,
which means that we try to determine the growth of potential output going forward, as well as the
future growth rate of the economy and the trend for inflation. We use judgment to decide on a course
of action, keeping in mind that the "ship" of the economy responds slowly to a change in the policy
interest rate, and that there could be headwinds or tailwinds to deal with. And because we get monthly
data on inflation and output, we can correct our course, if necessary, on subsequent policy interest
rate announcement dates.
Let me expand on this. In conducting monetary policy, the Bank uses three main strategies to reduce
uncertainty.
First, we use a variety of models to produce economic projections and to examine alternative
assumptions about key variables. The use of multiple models helps to provide comprehensive
information and analysis, and helps to guard against policy errors that could result from relying on a
single economic model. The models we use range from single-equation indicator models to
multiequation reduced-form models to dynamic stochastic general-equilibrium models, such as our newest
model of the Canadian economy, ToTEM.4
The second strategy we use to reduce uncertainty is to bring together a variety of information and
indicators
before we make an interest rate decision. These include both quantitative and qualitative
measures covering international and domestic economic developments, the regional business outlook,
monetary and credit conditions, and the views and expectations of financial market participants. As we
sift through this information, we try to look through the noise and discern fundamental trends. We look
carefully at both corroborating and non-corroborating evidence.
Finally, we apply judgment. The Bank of Canada does this by means of a committee that debates the
issues and comes to a decision. Interestingly, research suggests that the composition of a committee
and the structure of a meeting can affect the quality of decision making, both in central banking5 and
elsewhere. The Bank's committee is called the Governing Council. It consists of the Governor, the
Senior Deputy Governor, and four Deputy Governors. The Governing Council is advised by staff and
by a Monetary Policy Review Committee, which looks at the evidence and the projections, and raises
issues. Open discussion and debate are encouraged. Decisions benefit from the exchange of differing
views among members - what James Surowiecki calls the "wisdom of crowds."6 These differing views
arise largely from different weightings of various aspects of the analysis presented by Bank staff. The
Bank's clear goal - meeting the inflation target - helps to focus the deliberations. And with decisions
made every six to eight weeks, there are frequent opportunities to take new soundings and adjust
course.
A good example of how we apply these strategies is the way we estimate potential output. Potential
output is important in understanding inflation dynamics over time, but, as I said earlier, it cannot be
measured directly. We're not sure that our models fully capture potential output, especially when the
economy is undergoing significant structural change. To add to the challenge, some of the data used
in these models are frequently revised.
So, in addition to the readings we get from our models, we also consider a number of alternative
indicators of pressure on capacity. These indicators include the rate of capacity utilization, measures
of labour shortages, building vacancy rates, reports from our quarterly regional surveys of firms, and
the recent behaviour of inflation relative to expectations. Of course we also consider more direct
influences on inflation such as import prices, cost pressures such as wages relative to productivity,
and inflation expectations.
I should also mention that we meet, on a regular basis, with a wide variety of business people to
discuss their investment and hiring intentions, their costs and their pricing decisions, and any
constraints they may be facing. The information we obtain from these meetings helps us to interpret
the numbers and better informs our judgment.
Of course, the strategies I have mentioned complement one another. Taken together, they help the
Bank to arrive at a comprehensive and balanced view of developments in the Canadian economy, the
outlook for inflation, and the appropriate monetary policy action to keep inflation on target over the
medium term.
Conclusion
Let me conclude. In my remarks today, I've described how the Bank of Canada deals with the
uncertainty that underlies the conduct of monetary policy. The task of monetary policy is, and is sure to
remain, a challenging one, given the limits of understanding something as complex and dynamic as
the modern, globally integrated economy.
While dealing with uncertainty is a challenge for all central bankers, Canadians no longer have to
worry about one form of uncertainty that plagued us in the 1970s and early 1980s: that of high and
variable inflation. Canadians can be certain that the Bank of Canada will continue to direct its policy
actions at meeting the 2 per cent inflation-control target, and thus contribute to the sustainable growth
of the Canadian economy.
Uncertainty may indeed be the "defining characteristic" of monetary policy, but our clear inflation
target, and our success in meeting it, give us solid ground on which to stand.