The Bank of Canada is weighing whether to spell out how it responds to supply shocks in its monetary policy framework, including how much emphasis it places on the strength of the economy when tackling inflation. The central bank renews its framework every five years, with the 2026 review due by year-end. Policymakers have increasingly argued that the next iteration must reflect a more volatile inflation environment shaped by rising global protectionism, geopolitical tensions and the disruptive potential of artificial intelligence. “We are living in a world that is more prone to supply shocks, which are difficult for monetary policy,” Bank of Canada Governor Tiff Macklem told reporters in Washington last month. Such shocks, he said, create a “dilemma” because central banks cannot stabilise both inflation and growth simultaneously. Macklem stressed that the bank’s playbook must take into account where the economy sits relative to its potential. In other words, the bank has to assess the output gap before deciding how — or whether — to adjust interest rates when inflation is driven by supply constraints rather than demand. “We want to be as clear as we can up front about what we think our reaction function would look like in different circumstances,” he said. The framework serves as a credibility mechanism, publicly committing the bank to its 2% inflation target and outlining the factors that guide rate decisions. While it already allows for flexibility, adding specific language on supply shocks would clarify why the bank might choose a particular course of action — including holding rates steady even if inflation temporarily rises. “The value in making potential inaction more explicit in your framework is that it helps in your signaling to the market,” said Andrew Kelvin, head of Canadian and global rate strategy at TD Securities. Clearer communication, he added, could help reduce volatility in money markets, where interest rate expectations play a major role. Deputy Governor Sharon Kozicki laid out the Bank of Canada’s thinking in a key March speech, outlining how the bank might respond to different inflation and growth scenarios driven by supply shocks. In some cases, she said, officials would “look through” small or short-lived increases in price pressures. But if shocks generate large and persistent inflation, the bank would likely need to keep policy tight — even if the economy is already weak. This renewal is the first since the Covid-19 pandemic triggered severe supply-chain disruptions that helped push inflation to more than four times the bank’s target in 2022. Macklem has repeatedly emphasized that the economy was in excess demand when those shocks hit. “The consequences for inflation can come much faster and be much more rapid than if you’re starting at potential or in some excess supply,” he said in Washington. Currently, the major shocks hitting Canada stem from the Iran war-driven spike in oil prices and US tariffs. Both reflect broader shifts in global trade and geopolitics, raising the likelihood that Canada will face more episodes where inflation is high even as growth falters. Last week, the bank held its policy rate at 2.25%, saying the current stance “looks appropriate.” But Macklem stressed that rates could move in either direction if the outlook for inflation or growth changes. “The length of the trade dispute with the US or the blockade in the Strait of Hormuz are not things you can derive with an economic forecasting model,” Kelvin said. “Ultimately you only want to delay tightening if you believe the price shock in question is temporary.” Larry Schembri, who served as a deputy governor at the bank from 2013 to 2022, expects the renewed framework to reflect a world of more frequent supply shocks, including specific language to that effect. “There may be more emphasis on flexibility and managing uncertainty,” he said in an interview, noting that similar wording has increasingly appeared in governing council speeches. Otherwise, he expects the framework to remain largely unchanged — and possibly more concise. The 2% target isn’t under review. Policymakers say public confidence in the bank’s ability to return inflation to the 1%–3% range has held firm, a credibility that helped drive disinflation after the 2022 surge. Officials ultimately raised the policy interest rate to 5%, underscoring their commitment to the target. Canada’s previous prime minister, Justin Trudeau, once famously remarked that he doesn’t think about monetary policy. That’s almost certainly not the case for Mark Carney — a former governor of the Bank of Canada and Bank of England. The government plays a joint role in the framework renewal. But despite Carney’s expertise, Schembri expects the prime minister to take a relatively hands-off approach. Carney “has gone through the process before and is comfortable with where the outcomes have come out in the past,” Schembri said, adding that the prime minister is “very aware of how circumstances have changed over the last five or six years.” Paul Beaudry, another former deputy governor, said Carney’s presence may help safeguard the central bank’s independence by insulating it from potential external pressures — such as calls for a higher tolerance for inflation.
