the interest rate is raised today in response to an unexpected change in price and cost inflation, a fall in capacity utilisation must be expected. however, if the interest rate is increased in response to an unexpected pickup in demand for goods and services, the path will be a different one. in historical data, a higher interest rate can go hand in hand with both lower growth and higher growth. it is therefore demanding to identify the effects of interest rate changes when studying historical data series. moreover, the effect of an interest rate change will depend on whether the change is anticipated or comes as a surprise. for example, a lower - than - expected interest rate increase might easily be perceived as an expansionary monetary stance, even though the rate is actually being raised. expectations may also result in a change in market interest rates well in advance of an actual adjustment in the key policy rate. this may influence how quickly an interest rate change feeds through to the economy. furthermore, the impact will depend on the expected duration of the interest rate change. if the bank were to embark on a totally new monetary policy course, we would have to assume that this would result in a different path for the economy than if an interest rate hike occurs one month earlier than planned. chart : var model unemployment measured according to lfs. mainland hourly wage growth from quarterly national accounts. adjusted for tax changes and excluding energy products, seasonally adjusted figures. bis central bankers ’ speeches in order to analyse the effects of the interest rate, we need to study more than pure correlations. we need an analytical apparatus that allows the interest rate to be endogenous. a vector autoregressive model ( var ) model on norwegian data quantifies how the interest rate has reacted historically to other key economic variables. the model is based on statistical relationships between gdp, interest rates, exchange rates and inflation, taking into account that variables may be interdependent. all the variables are a function of lagged values of themselves and the other variables. to estimate the model, the relationship between some of the variables is predetermined in line with economic theory. for example, on the basis of well known economic relationships, assumptions can be made concerning the sequence in which the different variables will affect one another and we can impose the assumption that the interest rate will not affect gdp in the long term. a common approach to analysing the effect of the interest rate in models where it is endogenously determined is to apply

risks on global economic activity. we believed that as we worked toward our next projection, published in today ’ s mpr, we would probably be downgrading the economic outlook. that would mean a longer period of economic slack in canada, and would translate into a downside risk to inflation later in the forecast horizon. accordingly, six weeks ago, even though measured inflation had already ticked up, and looked likely to tick up even more, we indicated that the downside risks to our inflation outlook remained as important as before. in effect, the risks associated with the starting point for inflation had diminished, but the downside risks to the underlying fundamental drivers of inflation were growing. today, our report notes that total cpi inflation has moved to 2. 3 per cent, and core inflation to 1. 7 per cent. this pickup in measured inflation is attributable to the temporary effects of higher energy prices, exchange rate pass - through and other sector - specific shocks. it is not coming from any change in domestic economic fundamentals. bis central bankers ’ speeches today ’ s mpr presents a new economic projection in which there are both upside and downside risks to the inflation outlook. we believe these risks are roughly balanced. the downside risks to inflation associated with a below - target starting point have clearly diminished. the projection now includes a lower track for global economic activity, and a slower return of our economy to its full potential. our serial disappointment with global economic performance for the past several years of course means that we remain preoccupied with downside risks to economic activity and the fundamental drivers of inflation. as the temporary effects pushing inflation up begin to dissipate during 2015, unless the economy ’ s slack is absorbed over a reasonable timeframe, inflation will drift back down well below target. this will require above - potential economic growth fuelled by rising exports, followed by investment in new capacity. we believe that the ingredients are present for an eventual return to balanced and sustainable growth, with inflation on target, in 2016. we are anticipating that global demand will strengthen and, with the lower canadian dollar, indeed, will lead to a pickup in canadian exports and business investment. we expect real gdp growth to average around 2 1 / 4 per cent during 2014 – 2016. the economy is expected to reach full capacity around mid - 2016, a little later than we said in april. meanwhile, household imbalances continue to evolve constructively and recent data are broadly consistent with a soft landing in canada ’ s