Policy Rules and the Conduct of Monetary Policy in Canada

Pierre DuguayDeputy Governor

Outline • Introductory Comments

• Targeting Rule vs. Instrument Rule

• General vs. Specific Targeting Rule

• Bank of Canada Inflation-Control Strategy• IFB Instrument Rule as a practical answer in large scale

forward-looking model

• Approaches to deal with uncertainty

Lars’ Framework• Targeting Rule vs. Instrument Rule

• Response to determinants of aggregate demand and inflation vs. response to outcomes

• Drawback of Taylor Rule: Time-varying neutral rate

• General vs. Specific Rule• Transparency about horizon and implications for output

gap

Bank of Canada Inflation-Control Strategy• Model-Based Staff Economic Projection

• Numerical solution to optimal-control problem

• A Process to Deal with Uncertainty• Range of information

• Multiplicity of models

• Search for robust rule

• Search for leading indicators

• Communication and Transparency• Less is more

Model-Based Staff Economic Projection• Monetary Policy is endogenous

• Object of projection is to derive recommended path for policy instrument

• Alternative Scenarios• Alternative assumptions about key variables

• Alternative interest rate pathRobust Taylor rule

Constant interest rate for a period of time

• Evaluation of Forecasting Performance

IFB Rule in QPM• A Plausible Numerical Solution to Complex

Optimal-Control Problem• Brings inflation close to target over acceptable horizon

• Avoids excessive secondary cycles

• Selection of Parameters • Based on trade-off between variances of output and

inflation

• Made by Governing Council

IFB Rule in QPM

rslt = .3 rslt-1 + .25 (ygap+ygapt-1)/2

+ 3.5 (infgapt+6 + infgapt+7)/2

• Use of term spread mitigates trade-off between target and instrument

• Trade-off between variance of output and inflationImproved by weight on output gapWorsened by interest rate smoothing

Communications • Less is more: Keep story simple

• Outlook for output and output gap,

• core and total CPI inflation

• Broad direction of interest rates

• Factors that will be watched closely

• Not wanting to preempt private sector forecasts

• Focus on the logic of central bank decisions

• Highlight uncertainty

Conclusion• Monetary Policy as commitment to a Targeting

Rule using all relevant information

• Decision process factoring uncertainty

• Communication focusing on the logic of central bank decisions and highlighting uncertainty