C.D. Howe Institute: How the Bank of Canada Should Respond to Oil Shocks

The Bank of Canada should use its main forecasting tools more explicitly in explaining its strategy for responding to oil price shocks.

The effects of large oil price shocks on the Canadian economy are complex, as is the best response of monetary policy, but getting it wrong can be very costly, according to a new C.D. Howe Institute report. In “Ripple Effects: Oil Price Shocks and Monetary Policy,” author Steve Ambler argues that the Bank of Canada should use its main forecasting tools more explicitly in explaining its strategy for responding to oil price shocks.

“The effects of an oil price shock, as well as the best monetary policy response, are complex because of the many interactions between the petroleum sector and other sectors of the economy,” states Ambler. “The Bank of Canada is aware of these complexities, but it could make better use of the economic modelling tools it has at its disposal in its analysis of oil price shocks,” he adds. The improved use of these tools would also enable the Bank of Canada to communicate its strategy more effectively to the public, thereby enhancing the efficiency of monetary policy in Canada.

The report recommends that the main elements of the Bank’s strategy should include:

• using its global forecasting model, BofC-GEM, to forecast jointly the evolution of the world oil price and of world GDP;
• using its main forecasting and policy analysis model, ToTEM II, to forecast the evolution of the Canadian economy under the counter-factual assumption of flexible wages and prices; and
• using these forecasts more explicitly as part of its communication strategy, in particular to explain how monetary policy is offsetting the effects of nominal price and wage rigidities.

The Bank of Canada already recognizes that responding to real shocks such as oil price shocks is much more difficult than just stabilizing aggregate demand. Building on this recognition, the use of formal tools as a more integral part of its communication strategy would increase the transparency and predictability of the Bank’s monetary policy. “This kind of communication would increase its effectiveness and could only be a good thing,” concludes Ambler.

Click here for the full report.

The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada’s most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.

For more information contact: Steve Ambler, David Dodge Chair in Monetary Policy at the C.D. Howe Institute, professor in the Economics Department at the Université du Québec à Montréal; or Jeremy Kronick, Senior Policy Analyst, C.D. Howe Institute: 416.865.1904, or email: amcbrien@cdhowe.org.

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