The Bank of Canada has lost faith in the unemployment rate’s ability to predict the intensity of price pressures, an important shift that explains why governor Tiff Macklem has been so wary of overreacting to the fastest inflation in decades.

Canada decided in the early 1990s to use an inflation target to set interest rates. At the time, the economics profession was confident that there was a tight relationship between the percentage of working-age people who were unemployed and price stability.

Extensive research and deduction had determined that “full employment” could be defined as the point on a graph where the jobless rate coincided with moderate inflation, which the Bank of Canada’s leaders chose to define as keeping the consumer price index (CPI) advancing at an annual rate of about two per cent.

The link was one reason central bankers were confident they could do their part for economic growth and employment while also guarding against a repeat of the double-digit inflation that took hold in the 1970s and 1980s.

But economists started to doubt the predictive power of the “Phillips curve” in the years that followed the Great Recession. Unemployment rates in major economies dropped to levels that had previously been associated with full employment, yet inflation remained low — too low in some places, including the United States, where deflation remained a bigger threat than inflation.

In Canada, the jobless rate dropped to a record low of 5.4 per cent in May 2019, and averaged 5.7 per cent throughout 2019, levels that would have triggered alarms at the central bank because the country’s jobless rate had rarely fallen below six per cent. Yet there were few signs of significant upward pressure on the cost of most consumer goods and services.

“The evidence for Canada indicates that the relationship between labour market conditions and inflationary pressure has weakened and become difficult to measure,” Lawrence Schembri, a deputy governor at the Bank of Canada, said in a virtual speech hosted by the Canadian Association of Business Economics on Nov. 16.

“This uncertainty is closely related to the ambiguity about the level of maximum sustainable employment. Because the Phillips curve relationship has weakened, observed inflation provides less information about the level of maximum sustainable employment.”

Few of central banking’s closest observers will be surprised by those comments, as policy-makers have made clear in recent years that they were beginning to doubt previous definitions of full employment. Still, Schembri’s remarks — backed by forthcoming Bank of Canada research that he said shows the Phillips curve has “flattened” in Canada just as it has in the U.S. and elsewhere — rank as the most definitive statement that a Canadian central banker has made on the subject.

They also help explain why Macklem last month said that he and his deputies will be relying on a broad range of labour-market indicators to determine the path of interest rates going forward, and not simply a handful of popular indicators such as the unemployment rate.

Schembri’s speech was originally scheduled for August, but the election call forced the Bank of Canada to postpone, as it has a policy of keeping quiet during campaigns for federal office. If the remarks had been delivered as planned, there might have been less confusion about why the central bank appeared so calm as year-over-year increases in the CPI jumped out of its comfort zone of one per cent to three per cent over the summer.

Policy-makers had become highly distrustful of traditional indicators, and yet, instinctively, they would have sensed that the economy was a long way from full employment. “Our assessment of labour market conditions and underlying capacity and inflationary pressures is now more difficult,” Schembri said.

The CPI surged 4.4 per cent in September from a year earlier, the biggest increase since February 2003 and the sixth consecutive month that year-over-year increases in the index had exceeded three per cent. Schembri reiterated in his speech that he and his colleagues on the Governing Council think that most of that upward pressure is coming from “transitory effects of rising energy prices and global supply constraints,” emphasizing that “medium-term inflation expectations” remain “relatively well anchored due to our past success in achieving the inflation objective.”

To be sure, the Bank of Canada decided to hedge that bet last month. It opted to stop creating money to buy bonds and it advanced the potential timing for an interest-rate increase by three months by telegraphing that the public should expect higher rates in the second or third quarter of next year.

“Our forward guidance has been clear that we will not raise interest rates until economic slack is absorbed,” Macklem said in an opinion piece for the Financial Times that was published Nov. 15. “We are not there yet, but we are getting closer.”

Persistent inflation, even if it’s coming from forces over which monetary policy has little control, could force the Bank of Canada to raise interest rates sooner than labour-market indicators suggest is necessary if it starts to look like those medium-term inflation expectations are becoming unmoored.

The central bank is watching almost 50 different employment gauges and only 20 of them have returned to pre-pandemic levels. The goal is to get as many back to normal as possible, but Schembri indicated that he and his colleagues wouldn’t be waiting for all the dials to turn green before they begin raising interest rates.

“We’re not saying there needs to be zero unemployment,” he said in response to a question after his remarks.

• Email: kcarmichael@postmedia.com | Twitter: CarmichaelKevin