(Adds background, quote, details on uncertainty)
By Pushpa Balgobin
EDMONTON, Jan 31 (Reuters) - The global financial crisis has left the Canadian economy with persistent excess capacity, Bank of Canada Governor Stephen Poloz said on Tuesday, adding that geopolitical risk and uncertainty make it harder to know if policy is on track.
In a speech focused on the strengths and weaknesses of the bank's economic modeling over the years, Poloz said policymakers are always mindful of the uncertainties that might cause Canada to undershoot or overshoot the bank's inflation target.
"While we project that inflation will be sustainably at target around the middle of next year, 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," Poloz said in prepared remarks.
He also said it is "ill-advised" to reduce interest rate decisions to a simple mechanical rule given the uncertainty in economic models, and that the bank needs to explain underlying reasoning very carefully to ensure it is well understood.
In his speech to the University of Alberta business school, Poloz said that while it is true the notion of a zone generated by uncertainty can create a degree of tolerance for small shocks, a large shock or series of smaller shocks can tilt the balance of risks and prompt policy action.
Canada's central bank cut rates twice in 2015 to help stimulate the economy in the wake of falling crude oil prices, but has since left borrowing costs unchanged amid tepid growth and disappointing export strength. The bank is not expected to raise rates until 2018, even though the U.S. Federal Reserve has begun to tighten policy.
"We begin our interest rate deliberations with the policy path recommended by our models, but we are always mindful of the uncertainties, including the range of risks that might cause us to undershoot or overshoot our target," Poloz said.
He said factors that increase uncertainty, including geopolitical risk, can temporarily widen the zone in which the bank can be "reasonably assured that policy is on track," while resolution of uncertainties can narrow it.
Poloz said while current economic models are performing well, recent experience points to shortcomings that need to be addressed, and investing in the next generation of models is one of the bank's top priorities.
(Writing by Andrea Hopkins and Leah Schnurr in Ottawa; Editing by Dan Grebler)