Last Thursday’s Monetary Policy Report signals that the Bank of Canada intends to keep raising rates, but it also raises some interesting questions about the conduct of monetary policy, according to a new topic paper from TD Economics.

In the paper, Don Drummond, chief economist at TD, calls the latest MPR, “arguably one of the most informative ever produced, providing good insight into how the Bank conducts monetary policy and providing a clear signal that the monetary authority intends to continue raising interest rates in the coming months.”

Drummond notes that the Bank of Canada has signaled its intention to raise rates, and “we assume that the overnight rate will peak at 4.00% in early 2006.”

“Policy could be tightened by more, but the risks to the outlook suggest to us that rates will peak at a historically low level, as the Bank is likely to take a cautious approach once policy is at a significantly less stimulative position,” Drummond says.

“Regardless, the peak in rates may not last long. In an environment where energy prices flatten (the Bank’s assumption) or decline (our assumption) and economic growth slows (the Bank’s risk scenario and our base case forecast) it appears likely that monetary policy will begin a renewed easing cycle in late 2006,” Drummond suggests. “So, the main message ends up being that the Bank could very well end up pursuing an extremely activist policy in the months ahead in response to economic developments.”

But TD Economics also notes the highly informative MPR also suggests that “private sector economists need to understand the Bank’s estimate of potential a lot better, and this cannot be accomplished without the aid of the monetary authority.”

It notes that the report highlights that there should be more of a debate over mode versus mean forecasts. Mode refers to an average that’s determined as the most common value in a set of data, as opposed to mean, which is the simple average of values in a set of data.

The Bank of Canada is using mode forecasting, and TD Economics says it is not convinced that mode forecasts are the most appropriate. “However, even if the Bank does not change its forecasting approach, it is important for the private sector to understand whether the Bank is forecasting the mode outcome, as it would send different signals about the likely path of monetary policy than if the Bank is forecasting the mean outcome,” Drummond points out.