Slaying the Beast: The Bank of Canada's Ongoing Battle with Inflation

The surge of inflation as economies recovered from the COVID lockdowns of 2020 and 2021 took central bankers and most other observers by surprise. Canada was no exception. Year-over-year CPI inflation rose from -0.4 percent at its nadir in May 2020, to a peak of 8.1 percent in June 2022 before finishing 2022 at 6.3 percent.In this E-Brief, we start with a short overview of the evolution of the Canadian economy and the Bank of Canada’s monetary policy since 2020 (following up on Ambler and Kronick 2021). We focus on indicators relevant to the Bank of Canada’s inflation target. Second, we analyze several different indicators of the Bank’s monetary policy stance over the post-COVID period to understand where and by how much the Bank fell behind the curve as inflation took off. In this analysis, we use a series of different Taylor rules, which predict what the Bank’s policy rate should be based on economic factors such as the gap between actual and potential output, and the gap between actual inflation and the Bank’s target, complemented by a measure of the money overhang. We then explore possible reasons for the Bank’s delayed tightening.Our analysis confirms that the Bank of Canada’s policy rate lagged behind the ideal level predicted by different variations of the basic Taylor rule. Most of the predicted values for the policy rate have now peaked or are only slightly above the current overnight rate. Alongside the closing of the gap between the trend growth rate of broad money and inflation, the evidence suggests the Bank of Canada is right to pause its tightening cycle.