Bank of Canada policy, wrongly explained for you

In line with the hastily-revised expert consensus, the Bank of Canada left its benchmark interest rate unchanged at 0.75% today, saying it needed more time to judge the effectiveness of January's 25 basis point reduction. The non-move caused the Canadian dollar to rally very slightly, which is not something the central bank wishes to see, given that it is counting on a revival in non-oil exports to get the economy moving again.

By coincidence (or not), today saw a highly misleading article in the Toronto Star's op-ed page on Bank policy, penned by two left-leaning policy wonks. Their thesis is that the Bank is "quietly moving to the left" and adopting policies that have long been advocated by the NDP, Canada's main socialist(ish) political party.

This is simply wrong. The Bank's mandate for many years, as agreed with the Federal Government, is to keep inflation as close as possible to 2 percent.  When inflation is above this level, the Bank takes steps to bring it down, by tightening monetary policy (i.e. raising interest rates). When inflation falls below 2 percent -- and right now Canada is flirting with outright deflation, thanks to the fall in global energy prices -- the Bank tries to boost the inflation rate, by cutting interest rates. Notionally, this works by stimulating the real economy, but in Canada's case the most immediate impact on inflation is likely to be the result of a declining exchange rate.  None of this has anything to do with the NDP's supposedly superior policy prescriptions.

It's worth noting that it's not just in Canada that below-target inflation is giving central bankers pause. In the US, low inflation is allowing the Fed to delay rate hikes much longer than markets had expected, in order to allow the employment situation to improve further.  Over in the UK, Bank of England Governor Mark Carney has explicitly warned of the possibility of a brief period of deflation before underlying price pressures reassert themselves. There, too, the unexpected fall in inflation has stayed the central bank's hand.

The real problem with the Star op-ed piece is that the authors are claiming credit for a policy that hasn't really worked, and probably won't work any time soon. Low interest rates may be a necessary condition for getting the economy moving again, but the fact that the Bank of Canada is contemplating further cuts half-a-decade into the low rate era surely demonstrates that it's not a sufficient one. As Keynes and others observed long ago, expansionary monetary policy is like pushing on a string.

What's missing is an accompanying fiscal push. For ideological (but not economically logical) reasons, Canada's federal government has spent the past several years reducing spending in order to wipe out the budget deficit: the wrong policy at the wrong time. Low interest rates afford governments the opportunity to stimulate aggregate demand at minimal financial cost to taxpayers. Even in the Middle Ages, monarchs understood that the best time to rebuild the navy was when the economy was in bad shape, but right-wing governments in Ottawa (and in London) have been willfully blind to that truth.

Come October, the NDP can try to sell the case for more stimulative fiscal policy to the nation's voters. Given the extent to which the Harper government has poisoned the debate, that's likely to take more than a few ill-thought-out op-ed pieces in the Toronto Star.