Bank of Canada remains cautious on future rate hikes due to low- inflation risk

TORONTO -- The Bank of Canada remains cautious about future rate hikes as it measures the risk posed by low inflation that continues to fall short of the central bank's two per cent target, senior deputy governor Carolyn Wilkins said Wednesday.

"Just three weeks ago, the bank decided to leave the policy rate unchanged. We said at the time that while less monetary policy stimulus will likely be required over time, governing council will be cautious in making future adjustments to the policy rate," Wilkins said in remarks made in New York.

"One of the motivations for caution is that inflation has been in the lower end of the inflation target bands of one to three per cent for quite some time."

Inflation in Canada slowed over the first half of this year and remained in the lower half of the Bank of Canada's target range even as the economy grew quickly.

Caution, however, has its limits in times of uncertainty, Wilkins added, including those related to monetary policy and financial stability.

"Whether it is about how aggressive or how cautious policy should be -- getting the dosage right demands sound judgment about complex trade-offs," she said.

"And, like many businesses and households, central banks have established techniques to reduce, where possible, the level of uncertainty they experience."

Speaking before the Money Marketeers of New York University, Wilkins said the central bank is particularly focused on data that indicate how wages and potential output are progressing, as well as the effects of the two interest rate increases made over the summer. The bank is also following NAFTA negotiations closely.

While higher household debt has likely heightened the sensitivity of spending to interest rate increases, Wilkins said it is difficult at this time to know by how much. There is also uncertainty about the interaction of interest rate increases with the recent tightening of macroprudential rules.

To understand how the bank factors uncertainty into its policy decisions, Wilkins paralleled a scenario involving business people considering large capital expenditures who have the option value of waiting until they are more sure of the returns.

"As with investment, fixed costs of changing policy direction may explain a central bank's aversion to reversals and motivate a wait-and-see approach to policy," she said.

That said, she added, it's unclear how costly policy reversals are for the real economy.

"It is possible that the perceived costs are self-reinforcing because reversals are so rare that they are viewed as policy errors when they do occur, rather than as a sensible reaction to new information."