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Buried within the renewal of the Bank of Canada’s mandate is the admission that the central bank is limited in using interest rates to deal with severe downturns in the future. Economists have long used the concept of a neutral rate to guide policymaking. The neutral rate should support the economy operating at full employment while maintaining inflation at a constant rate. Put slightly differently, this is the rate at which monetary policy is neither restrictive nor expansive. Try as they may, central bankers cannot actually directly observe this neutral rate but must infer it using a variety of measures of economic activity. The previous Governor of the BoC often spoke that the current interest rates were lower than the ‘neutral rate’ and there was room to raise rates without any adverse impacts on employment or growth.

The BoC and the Government of Canada jointly acknowledged on December 13^th, that:

 “neutral interest rates are likely to be lower than in the past, which means that central banks will have less room to lower their policy interest rates in the face of large adverse shocks to the economy”( Joint Statement). 

In layman terms, interest rates will remain at these relatively low levels indefinitely and this will hamper the Bank’s ability to stimulate economic activity at a time of economic malaise. The notion of a neutral rate became a topic of considerable debate after the 2008 financial crisis when the central banks around the world expanded liquidity quickly in the hope of lowering long term interest rates. That debate continues to this day, especially in the face of the recent inflationary spurt worldwide. Yet, no central bank has called for a rapid and sustained increase in their policy rates in response to current price conditions.  

The BoC now accepts that the nominal neutral rate lies between 1.75% and 2.75%, some 50 basis points lower than estimates provided earlier in 2019( Neutral Rate in Canada). More to this point are the reasons which behind this decline in the neutral rate. The BoC notes that the pandemic has lowered the global neutral rates, especially given the high level of savings for precautionary reasons. The rise in worldwide savings have been a major factor in driving down interest rates everywhere. And, Canada cannot isolate itself from these global forces. Domestically, the pandemic has a negative effect on Canada’s potential growth by lowering productivity performance and reducing the growth of the labour force. Despite a pick up in growth since the low point of mid-2020, there remains considerable uncertainty which affects business confidence resulting in a scaling back of new capital projects aimed at improving productivity. Also, there is considerable turmoil within the labour market as job openings, quit rates and joblessness offer mixed signals as to the health of the labour market. 

By lowering the neutral interest rate, the BoC concedes that the Canadian economy has a growth problem. Canada’s potential growth is estimated to be just 1.6%which is some 50 bps lower than existed in the previous decade.. Its business sector continues to underperform and its labour market is experiencing considerable upheaval in response to the pandemic’s impact on the workplace, job satisfaction and wages. Given the degree of uncertainty surrounding the omicron virus, it remains to be seen whether the bank rate will even reach the neutral rate.