Monetary Policy Framework Renewal | 2021 | Page 29
financial vulnerabilities or macroeconomic imbalances (Beaudry 2020a).
37
Monetary policy can mitigate some concerns about elevated financial
vulnerabilities by flexibly adjusting both the horizon for returning inflation to
target and the corresponding interest rate path (Bank of Canada 2011; 2016).
One tool to help quantify these potential trade-offs is the Bank’s recently
developed growth-at-risk framework (Adrian, Boyarchenko and Giannone
2019; Duprey and Ueberfeldt 2020; Boire, Duprey and Ueberfeldt 2021). While
the growth-at-risk framework offers important insight, research continues on
how best to model the intertemporal trade-off generated by elevated debt
levels and incorporate it into monetary policy decision making.
38
Research is continuing into the mix of policies that could best mitigate and
limit the buildup of financial vulnerabilities.
39
Based on the recent Canadian
experience, a variety of prudential, macroprudential and housing policy
instruments exist that are better suited than monetary policy to address these
vulnerabilities (Box 6). Further investments in strengthening Canada’s
macroprudential policy framework could also potentially increase the
effectiveness of these policies (International Monetary Fund 2019). Given the
importance of financial stability for good macroeconomic performance, this
issue will remain important for monetary policy.
40
37 The Bank discussed the possibility that some alternative paths for the policy rate could have similar implications
for inflation but different implications for the level of financial vulnerabilities. This illustrates that in some
situations no trade-off may exist between stabilizing inflation today and stabilizing it tomorrow in the face of
financial vulnerabilities. Monetary policy can also be a blunt and costly tool to target financial vulnerabilities,
especially compared with other tools such as macroprudential policies (Bank of Canada 2016).
38 The growth-at-risk concept provides a quantitative assessment of the trade-offs between different risks. In this
framework, choosing a rate path to minimize the departure of inflation from the target not only minimizes
macroeconomic risks to economic growth but also has consequences for financial stability risks to economic
growth. The framework still involves an element of judgment, as many of the relationships are estimated
imprecisely. Current research focuses on developing a framework that is more explicit about the mechanisms at
play—for example, exploring the formation of expectations, which can play a key role in the development of
financial vulnerabilities because departures from rational expectations can amplify boom-bust dynamics.
39 For a recent example, see Schroth (2021).
40 A related consideration is that high levels of debt may affect the transmission of monetary policy (e.g., Kaplan,
Moll and Violante 2018; Cloyne, Ferreira and Surico 2020). For example, Kartashova and Zhou (2020) examine how
Canadians with mortgages, which account for the majority of household debt, respond to changes in interest rates
when their mortgages come up for renewal. The authors find that changes in interest rates at renewal have an
asymmetric impact on consumer durable spending, deleveraging and defaults, with borrowers deleveraging if
rates rise at renewal. These asymmetric responses point to a risk that consumption could become more sensitive
to changes in interest rates.