Key challenges for the conduct of monetary policy Over the past decade or so, several economic trends have accelerated, affecting the Canadian economy. The 2008-09 global financial crisis and the COVID-19 pandemic have had significant impacts on the global economy and financial system. And forces such as demographic shifts, globalization, new digital technologies and climate change are affecting the economic landscape. These economic and social trends raise two key challenges for the conduct of monetary policy: The persistence of low interest rates since the global financial crisis has led to a growing consensus that low neutral rates are likely to continue for some time, constraining central banks' ability to provide stimulus through reductions in their policy rate. Major forces have increased uncertainty and made it harder to pin down the maximum level of employment that the economy can sustain before inflationary pressures build. In addition, when conducting monetary policy, central banks need to consider the historically high levels of debt held by households and businesses. Despite significant advances in prudential financial regulations, particularly with respect to housing finance, a prolonged period of low interest rates could contribute to a buildup of financial vulnerabilities. Thus, while a number of prudential, macroprudential and housing policy instruments are better suited than monetary policy to address financial vulnerabilities, the possibility that monetary policy could exacerbate these vulnerabilities remains an important consideration.

A world of low neutral interest rates The low interest rates observed in advanced economies since the global financial crisis partly reflect low neutral rates, which many agree are likely to persist in the coming years (e.g., Del Negro et al. 2019). This persistence means central banks will have less room to lower their policy rates before hitting the effective lower bound (ELB). As a result, ELB episodes are more Monetary Policy Framework Renewal | 2021 | Page 21 likely to occur in the future than they were during the first two decades of inflation targeting. Given the tendency for inflation to be below target during ELB episodes, more frequent ELB episodes may make it difficult for the Bank of Canada to achieve its inflation target of 2 percent. To assess the likelihood of an ELB episode, we use the concept of the neutral rate of interest. The neutral rate is defined as the policy rate that coincides with output at potential and inflation equal to target after the effects of cyclical shocks have dissipated. Although estimates vary across countries and time periods, most agree that the neutral rate of interest has declined in advanced economies since at least the early 2000s and is likely to remain near its historical lows over the coming years. 21 In Canada, both the actual policy rate and the estimated neutral rate have declined since the early 2000s (Chart 3). In the mid-2000s, the Bank assumed a nominal neutral rate of roughly 5 percent. Since the global financial crisis, estimates have shifted downward, and the 2021 Canadian nominal neutral rate estimate is in the range of 1.75 to 2.75 percent, with a midpoint of 2.25 percent (Brouillette et al. 2021). 21 See, for example, Laubach and Williams (2003), Del Negro et al. (2019) and Feunou and Fontaine (forthcoming). 0 2 4 6 8 10 12 1991 1996 2001 2006 2011 2016 2021 Effective lower bound (+25 basis points) Policy rate Estimated neutral rate Note: The grey range is the estimated range of the neutral rate, and the black line is the mid point of the range. Source: Bank of Canada % Last observation: October 2021 Chart 3: The Bank of Canada policy rate and the estimated neutral rate have declined Monthly Monetary Policy Framework Renewal | 2021 | Page 22 This decline in the neutral rate makes it more likely that monetary policy will reach its ELB in future economic downturns. With a lower neutral rate, central banks have less room to reduce the policy rate in response to negative shocks before reaching the ELB. Staff estimate that the likelihood that adverse economic shocks will result in the policy rate hitting its stated ELB of 0.25 percent has increased from 6 percent in 2016 to about 17 percent in 2021 (Chart 4, panel a).22 The lower neutral rate has also extended the projected average duration of ELB episodes from 2.3 quarters in 2016 to about 7 quarters in 2021 (Chart 4, panel b). The recent experience with the COVID-19 pandemic illustrates the implications of ELB episodes for inflation (see Chapter 2). Even with a rapid decrease of the policy rate to the ELB in response to weak aggregate demand, inflation fell well below the 2 percent target. This is consistent with analysis that ELB episodes often see inflation below target. The risk of frequent and prolonged ELB episodes where inflation is persistently below target has raised concerns that inflation, over the medium term, may average below 2 percent. If inflation were to average below target for a prolonged period, households and firms could adjust their inflation expectations downward. This would cause the ELB to become even more of a 22 Staff used the Bank's main dynamic stochastic general equilibrium model, the Terms-of-Trade Economic Model (ToTEM) III, for this analysis. See Corrigan et al. (2021) for details on ToTEM III. data Chart 4: The probability of being constrained by the effective lower bound on the policy interest rate has increased Note: In both panels, the 2021 real neutral rate is 0.25 percent, the 2016 real neutral rate is 1.25 percent and the real neutral rate before the global financial crisis is 3 percent. Rates are calculated using the Bank of Canada's Terms-of-Trade Economic Model (ToTEM) III. Source: Bank of Canada 0 2 4 6 8 2021 real neutral rate 2016 real neutral rate Real neutral rate before global financial crisis Quarters b. Average duration of effective lower bound episodes 0 5 10 15 20 2021 real neutral rate 2016 real neutral rate Real neutral rate before global financial crisis % a. Relative frequency of a binding effective lower bound Monetary Policy Framework Renewal | 2021 | Page 23 constraint because it would be more difficult to reduce the real policy rate. As a result, central banks need to adjust how they conduct monetary policy. Changes could include using a larger suite of monetary policy tools and approaches more often. This would better mitigate the impacts of ELB episodes on employment and output and help avoid inflation remaining below 2 percent for extended periods of time.

Increased uncertainty about the level of maximum sustainable employment Major forces, including demographic changes, technological advancements, globalization and shifts in the nature of work, have had profound effects on the Canadian labour market. These evolving forces have increased uncertainty around assessments of the level of maximum sustainable employmentthe highest level of employment that the economy can sustain before inflationary pressures build. Added to this uncertainty is increasing evidence that the relationship between economic slack and inflation is relatively weak as long as inflation expectations remain firmly anchored.23 As a result, inflation near 2 percentby itselfis no longer a sufficient signal that the economy has reached maximum sustainable employment. The increased uncertainty about the level of maximum sustainable employment poses a challenge to the conduct of monetary policy. When deciding on monetary policy actions, the Bank looks ahead and adjusts the degree of monetary stimulus to affect the level of total demand and help close the output gap. Because inflation expectations are well anchored at 2 percent, inflation should return sustainably to target when slack is absorbed and the economy is restored to maximum sustainable employment and its productive capacity. However, with increased uncertainty regarding the level of maximum sustainable employment, the risk of misjudging the appropriate stance for monetary policy has increased. Identifying the level of maximum sustainable employment has never been easy. Indeed, many researchers have documented the wide confidence intervals associated with estimates of the output gap or of the non23 Economic slack refers to resources in the economy that are not being fully utilized. These resources include people who would like to work but are unable to find a job as well as machinery and equipment that are not being used. Monetary Policy Framework Renewal | 2021 | Page 24 accelerating inflation rate of unemployment (NAIRU)a commonly used measure of maximum sustainable employment. It should not be surprising that identifying maximum sustainable employment is challenging because the labour market itself is not one single market. It is, in fact, the sum of many markets, differentiated by a variety of characteristics, including skill, industry and location. Consequently, it is difficult to know whether everyone who wants to be working is doing so, in a job that matches their skill set. Ongoing structural changes in labour markets over the past few decades have caused the level of maximum sustainable employment to change, making this challenge even greater (Box 4). For example, an aging population and higher levels of immigration have had an impact on the mix of workers' skills. At the same time, globalization and technological changeespecially digitalizationhave affected labour demand. These still-evolving forces have shifted the demand for and supply of different skill sets, and their net effect on maximum sustainable employment is unclear.

Evolving uncertainties about the estimation of the output gap and maximum sustainable employment Economic research has documented the substantial uncertainties around the measurement of unobservable variables, such as the output gap and maximum sustainable employment.24 These variables feature prominently in the macroeconomic models that central banks use to predict when inflationary pressures will emerge. Structural changes in labour marketsdriven by ongoing demographic shifts, globalization and technological change, especially digitalizationhave heightened these uncertainties. These changes are affecting the demand for and supply of different skill sets and possibly creating job mismatches. Since the 2008-09 global financial crisis, employment rates (defined as the ratio of employed individuals to changes in economic conditions. The evolving view of the relationship between inflation and economic slack reflects not only the success of inflation targeting in anchoring inflation expectations since the 1990s but also recent research (Box 5).

Implications of a flat Phillips curve The Phillips curve (PC) plays an important role in macroeconomic modelling in academia and at central banks. Broadly speaking, the PC relates inflation to a measure of economic slack, such as the output gap or the deviation of the unemployment rate from an estimate of its natural rate and expected future inflation. 31 Although estimates of the PC can depend on model specification and sample period, evidence is growing that the slope of the PC since the early 1990s has been relatively flat (Landry and Sekkel, forthcoming).32 A flatter slope of the PC means that large fluctuations in the output gap are consistent with relatively stable inflation (Ball and Mazumder 2011; Del Negro et al. 2020). The flatness of the slope of the PC has important implications for how informative inflation is about whether the economy is close to the maximum sustainable level of employment (or potential output). In practice, inflation is measured imperfectly, and transitory shocks (e.g., short-term supply disruptions) can temporarily affect the level of inflation. With a flat PC and shocks to inflation, inflation can often be close to 2 percent even if the economy is below (or above) maximum sustainable employment or potential output. An example that illustrates how a flatter PC could lead to current inflation being less informative about maximum sustainable employment is shown in Chart 5-A. Building from a two-equation model where inflation and potential output are both subject to unobservable shocks, Cacciatore, Matveev and Sekkel (forthcoming) infer the probability distribution for the output gap, conditional on inflation being at 2 percent. 34 Shaded areas in the chart represent the probability of the level of the output gap (with 95 percent confidence). The two curves correspond to pre- and post-1990s estimates of the slope of the PC reported by Hazell et al. (2020). With a flatter slope (seen in the smaller value of the slope coefficient, ), the distribution of the output gap becomes much more dispersed. As a result, with inflation at 2 percent, a flatter slope means that confidence that the output gap is closed is much lower. A relatively flat Phillips curve poses a two-sided risk to monetary policy. On one hand, it suggests that a more patient approach to tightening monetary policy could have modest impacts on inflation in the near term. On the other hand, it implies that if monetary policy is slow to respond to a sustained 34 Carter and Mendes (forthcoming) offer an alternative approach that allows the PC to take a nonlinear, convex shape under which the curve steepens as the output gap becomes more positive. In this context, inflation outcomes are relatively uninformative about the maximum sustainable level of output at low levels of output but become more informative at higher levels of output. Chart 5-A: A flatter Phillips curve means inflation is less informative about the output gap Note: The two distributions of the output gap are derived using alternative values of the slope of the Phillips curve, , taken from Hazell et al. (2020). The pre-1990s value is 0.0107 and the post-1990s value is 0.005.

A relatively flat Phillips curve poses a two-sided risk to monetary policy. On one hand, it suggests that a more patient approach to tightening monetary policy could have modest impacts on inflation in the near term. On the other hand, it implies that if monetary policy is slow to respond to a sustained buildup of inflationary pressures, bringing inflation back to its target may be costly. With a flatter Phillips curve, observing inflation near 2 percent is less likely to imply that the economy is operating near maximum sustainable employment (see Box 5). Given the uncertainty associated with ongoing structural changes in labour markets, this suggests that it is now more difficult to know when maximum sustainable employment is attained and the output gap is closed. This raises the question of whether changes to the practice of monetary policy could help the Bank better assess the maximum level of sustainable employment consistent with the 2 percent target for inflation. For example, a patient approach to applying monetary stimulus could help draw individuals with limited attachment to the labour force into more productive employment and help reduce persistent disparities in economic opportunity and income. However, inflation expectations must remain well anchored for monetary policy to succeed in keeping inflation on target.

Historically high levels of private debt The historically high level of debt relative to gross domestic product (GDP) among households and businesses remains an important consideration for the conduct of monetary policy. Since 1990, household sector debt relative to GDP has doubled and now exceeds 100 percent.35 Although private, nonfinancial business debt has grown more slowly since 1990, it also exceeds 100 percent of GDP.36 With the expectation that interest rates will remain low as a result of a low neutral rate of interest, the risk of a further buildup of debt and associated financial vulnerabilities remains a concern (e.g., see the Bank's 2021 Financial System Review). Since the 2016 renewal of the monetary policy framework, the Bank has been mindful of the risks associated with high levels of household or corporate debt (Bank of Canada 2016). Elevated debt levels may create a difficult tradeoff between stabilizing inflation today and doing so tomorrow in the face of 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.

Macroprudential and monetary policyCanadian experience since the global financial crisis For over a decade, the Bank of Canada has emphasized the evolution of household financial vulnerabilities in its Financial System Review. Macroprudential policies have adapted to address the vulnerabilities in Canadian housing and mortgage markets. In particular, federal authoritiesboth the Department of Finance Canada and the Office of the Superintendent of Financial Institutions (OSFI)implemented and expanded stress tests for insured and uninsured mortgages. These built on earlier measures introduced between 2008 and 2012 to lower the riskiness of new mortgage debt. Following the global financial crisis, federal mortgage insurance qualification criteria were tightened. Between 2008 and 2012, the maximum amortization of insured mortgages was lowered from 40 to 25 years, and the loan-to-value (LTV) ratio limit was reduced from 100 to 95 percent for a purchase and from 95 to 80 percent for refinancing.41 Overall, the rule tightening likely contributed to slower credit growth after 2012 despite continued low interest rates (Chart 6-A). The Bank's policy rate remained constant between September 2010 and January 2015. In 2015, a sharp decline in oil prices prompted the Bank to cut its policy rate to 50 basis points. This reduction, along with continued downward pressure on longterm yields in international markets, pushed five-year fixed-rate mortgages down to then-record lows of 2.4 percent (Chart 6-A). This period of low mortgage rates also saw a steady increase in the share of insured mortgage originations (with LTV ratios above 80 percent) and uninsured mortgage originations (with LTV ratios less than 80 percent) with a loan-to-income (LTI) ratio over 450 percent. To counteract this growth of highly indebted households, the Department of Finance Canada expanded the stress test for insured mortgages in 2016, while OSFI expanded the stress test for uninsured mortgages in 2018. 42 These tightenings of policy by federal authorities effectively increased by 200 basis points the rate used to calculate the maximum debt service ratio to qualify for a mortgage. The result was a sharp decline in the share of newly originated mortgages with an LTI ratio greater than 450 percent. 43 Overall, the recent Canadian experience suggests that the macroprudential measures on mortgages from 2008 to 2012, along with the expansion of stress tests in 2016, have dampened credit growth resulting from lower policy rates. The stress test on insured mortgages has worked to limit the growth of highly leveraged borrowers (with a high LTI ratio and an LTV ratio at 95 percent). However, interest rates still appear to have a strong effect on the Canadian housing market and mortgage originations.44 The bottom line is that evidence suggests that macroprudential measures have countered the buildup of financial vulnerabilities in Canada, lowering the likelihood and severity of a shock affecting the entire financial system. However, household debt remains elevated, and house prices have continued to increase rapidly. Thus, the ability of macroprudential policy to prevent excessive risk taking during a period of low interest rates may be incomplete. For this reason, monetary policy must be mindful of its potential effects on financial vulnerabilities.

I just need a short summary on this chapter.