Aging Population Throws Wrench in Monetary Policy Goals-C.D. Howe
March 27, 2018 – Canada’s aging population has acted as a drag on the effectiveness of monetary policy since the financial crisis, according to a new report from the C.D. Howe Institute. In “Faulty Transmissions: How Demographics Affect Monetary Policy in Canada” authors Steve Ambler and Jeremy Kronick examine the impact of demographics on the effectiveness of monetary policy through the lens of inflation and unemployment.
Over the past decade, they note, Canada has averaged 1.5 percent inflation, below the Bank of Canada’s 2 percent target, despite rock-bottom interest rates and stimulative monetary policy. The study suggests that demographics offers a plausible explanation for why inflation has not reached higher levels post-economic crisis.
“Canada’s aging population is likely a leading cause of the systematic undershooting of inflation we have seen since the financial crisis,” says Ambler. “Specifically, an aging population that takes on less debt is less sensitive to changes in the interest rate.”
The interest rate and credit channels of monetary policy help explain this result. Households accumulate debt as they go through the early stages of adulthood, but are able to pay off this debt as they age and end up creditors by the time they hit life’s later stages. Thus, younger households are more sensitive to changes in interest rates than older ones, since they need more credit.
Examining a sample period of Q1/1992 to Q4/2015, the authors test the theory that demographics has played an important role in slowing down monetary policy’s impact on key macroeconomic variables. They find that low interest rates boost household spending and therefore inflation, but by less when households are not as indebted. What this means is that, if not for aging, monetary policy would have been more effective through its impact on spending.
“Credit plays an important role on the real economy – it magnifies the reduction in the effectiveness of monetary policy that comes from an aging population,” Kronick explains. “Because of population aging, lower interest rates have not generated the typical increase in spending, leading to subdued inflation and lower economic growth.”
The results show that the inflation-targeting policy framework in Canada is in reasonably good shape, but is not perfect. “If further population aging continues to reduce the effectiveness of monetary policy, this could eventually undermine Canada’s inflation-targeting regime,” Ambler says.
Meeting the Bank of Canada’s inflation target will require more significant changes to the overnight rate target and, in the case of expansionary monetary policy, will be made more difficult by a lower neutral rate of interest, which may result in a quicker move to unconventional monetary policy. The results in the study should help the Bank of Canada adjust its analysis accordingly, conclude the authors.