Monetary Policy in a Volatile World: ToTEM Simulations

Relative to the pre-pandemic period, supply shocks in the Bank of Canada’s Terms-of-Trade Economic Model (ToTEM) have been moderately larger since 2022, and markedly larger if the 2020–21 pandemic is included. ToTEM simulations show that moderately larger supply shocks increase inflation volatility without materially worsening the medium-term inflation outlook or significantly increasing recession risks. When supply shocks are especially large, however, episodes of core inflation outside of the 1–3% control range become both more frequent and more persistent, and recession risks rise sharply. In these environments, monetary policy faces more challenging trade-offs as stabilizing inflation increasingly entails costs to real activity, and even more aggressive policy rules cannot replicate inflation outcomes in more stable periods. Amplification of inflationary risks—due to de-anchoring inflation expectations or high cost pass-through—worsens these trade-offs and reduces the scope to look through inflationary shocks. When such amplification is present, a much tighter policy response than the one embedded in the historical rule is warranted to manage more frequent high-inflation states and ensure price stability.