Economic models have limits in disruptive times - bank governor

Ottawa - Uncertainty continued as the main theme for Bank of Canada Governor Stephen Poloz, who in a speech Tuesday highlighted the challenges of economic modeling in times of disruptive change.

In remarks to the University of Alberta School of Business, Poloz outlined how uncertainty means policy making is far from an exact science and judgment matters. Geopolitical risks for example could increase the central bank’s tolerance of small shocks, he said.

Uncertainty has been a central narrative for the Bank of Canada governor for months, but one that has taken a more pointed focus since President Donald Trump’s election victory.

Poloz cited the risk of disruptive US trade policies in a rate decision two weeks ago, even as he’s downplayed any possible benefits.

He was asked about the Trump uncertainty again on Tuesday.

"The way we think of it now is uncertainty has risen in the wake of the election and that is likely to feed through to investment thinking," Poloz said in response to questions after his speech in Edmonton, which was a more technical look at economic modeling.

But here too, the idea of the role of uncertainty was central. Poloz said in the speech that uncertainties such as geopolitical risks can limit the efficacy of economic modeling, while underscoring the importance of judgment in policy making.

Policy crossroads

"The state of the art today is light years ahead of what was state of the art 40 years ago," said Poloz, according to the text of his speech. "But ultimately, storytelling remains what is important. That has not changed."

The comments reflect a growing realization among policy makers globally that central banking is at a crossroads, having failed to predict the last recession and struggling to explain and correct the period of prolonged sluggish growth since the crisis.

It also falls into a recent pattern of Bank of Canada officials warning that long-established economic relationships may not be as robust - as with Poloz warning over the past year about the faltering links between the Canadian and US economies.

Poloz cited different types of uncertainties that require the bank to have a "risk-management" approach to monetary policy.

There is "inherent" uncertainty that exists even when models are performing well - the sort of risks associated with regular margins of error and assumptions, and uncertainty generated by "the risks to our inflation forecast."

Then, there are disruptive changes like the financial crisis that make it "more likely that its suggested interest-rate path will lead to missed targets."

"Interpreting, weighing and managing those risks approaches art, but the art is built on the science of our models," Poloz said.

Spare capacity

Adding to the need for judgment, the "starting point matters."

"We are well aware that the lingering aftermath of the crisis has left the Canadian economy with persistent excess capacity, and inflation has been in the lower half of our target range for some time,” he said. That’s why reducing monetary policy to simple mechanical rules doesn’t work.

"The fact that there are so many sources of uncertainty, some of which cannot be quantified, makes the risk-management exercise highly judgmental," he said.

One outcome is that the more temporary uncertainty there is, the wider the central bank’s zone of risk tolerance could be. At the same time, Poloz cautioned that "uncertainty does not equal indecision."

"It is true that the notion of a zone generated by uncertainty can create a degree of tolerance for small shocks. At the same time, a large shock - or perhaps, an accumulation of smaller shocks - can tilt the balance of risks to projected inflation and prompt policy action."