Defining “Neutral” Level for Interest Rates a Smoke and Mirrors Game: C.D. Howe Institute

TORONTO, While the Bank of Canada expects the Canadian economy to return to full employment by the middle of 2012, its critics have stressed the need to raise interest rates to a "neutral" value by then to keep inflation stable. But defining this neutral level, normally associated with full employment, is a bit of a smoke and mirrors game, according to a report from the C.D. Howe Institute.

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In "Natural Hazards: Some Pitfalls on the Path to a Neutral Interest Rate," David Laidler, a leading monetary economist, questions the theoretical concept of the "natural interest rate" that underlies the idea that there is a well-determined and stable neutral value for market rates. He notes that much discussion of this natural rate "presumes, first, that such a value is grounded in the basic structure of the Canadian economy and, second, that this structure is stable over time, so that the neutral interest rate can be inferred from past data." Today's monetary policy models, Laidler notes, treat the Canadian economy as if its output was only one thing, and its people all alike in their economic decision making, but in the real world, spending decisions depend on expected returns in specific lines of business, which are diverse and variable over time, and economic fundamentals are not their only determinants. "The neutral interest rate's value is hence extremely difficult to estimate, making other policy indicators highly relevant," says Laidler. He points out that recent survey data on business intentions and expectations have shown more signs of expansion lately, but, along with still subdued rates of money growth, they do not as yet signal any imminent threat of an upsurge in long-term inflationary pressures in Canada. "These factors suggest that there might be something to be said for the Bank of Canada's current caution towards raising interest rates," concludes Professor Laidler. For the report go to: cdhowe.org