Dec. 22, 2021
Nothing short of a recession will stop the Bank of Canada from raising interest rates early in the new year, perhaps as soon as Jan. 26, the day officials conclude their next round of policy deliberations.
“The aim is to bring inflation back to target in a way that doesn’t choke off the recovery,” governor Tiff Macklem said in a year-end interview on Dec. 15. “That recovery is now well advanced and inflation is well above target. We’re not comfortable with where inflation is. It’s well above target.”
Inflation, as measured by the consumer price index (CPI), the broad measure the Bank of Canada has used to guide the interest-rate setting since 1991, is testing five per cent, a pace uncomfortably surfacing memories of what it was like before the central banking profession embraced inflation targeting three decades ago.
Finance Minister Chrystia Freeland re-upped the Bank of Canada’s five-year mandate on Dec. 13, once again giving Macklem clear marching orders to primarily focus on keeping the CPI advancing at a pace of about two per cent per year.
Two days later, Statistics Canada reported the CPI increased 4.7 per cent in November, matching October’s surge. Headline inflation had only reached that speed once since the Bank of Canada began using interest rates to calibrate price pressures. The CPI also increased 4.7 per cent in February 2003. The following month, the central bank raised its benchmark interest rate by a quarter point. It would do so again in April, lifting the policy rate to 3.25 per cent.
There are similarities between now and then. Back in early 2003, David Dodge’s Bank of Canada worried it was losing its grip on prices. “Persistent above-target inflation rates over the past few months reflect not only the impact of higher-than-expected crude oil and natural gas prices, but also continuing increases in auto-insurance premiums and price pressures in certain sectors such as housing, food and some services,” the central bank said at the time while explaining its decision to raise borrowing costs. “The level of economic activity in Canada remains near full production capacity. In these circumstances, the persistence of above-target rates of inflation has elevated the risk of an increase in inflation expectations.”
Macklem is also worried workers will start demanding wage increases in excess of five per cent, and suppliers will insist on prices that match their surging input costs. The Bank of Canada earlier this month reiterated it thinks inflation will recede over the second half of next year as supply catches up to demand. But that forecast assumes the public buys into it. If they don’t, faster inflation could become a self-fulfilling prophecy.
“We do think there are good reasons why (inflation) will ease back in the second half of next year, and our job is really to make sure the price increases we’ve seen don’t become enduring inflation,” Macklem said. “The two key elements of that are keeping expectations well anchored and adjusting our monetary stance so we don’t build up a head of excess demand that would create more ongoing inflation.”
The economy has recovered from the COVID-19 recession faster than most anyone expected, especially those who were predicting a depression back in March and April of 2020. The reason for the relatively speedy rebound is obvious: rich economies, including Canada, deployed unprecedented amounts of the fiscal and monetary stimulus during the crisis.
They probably overdid it, but after a hasty pivot to austerity slowed the recovery from the Great Recession, the consensus among policy-makers this time was to err on the side of growth. Suppliers retrenched in anticipation of a significant downturn, but demand held up because of the generous emergency benefits. As a result, factories fell behind, ports snarled and commodity prices soared.
The mismatch between demand and supply stoked inflation around the world. Central bankers assumed balance would be quickly restored, but it hasn’t happened so far, prompting the United States Federal Reserve, Bank of England and others to accelerate their plans to raise interest rates.
Macklem began the year thinking he might try to push the jobless rate back down to its pre-pandemic figure of about 5.5 per cent, the lowest level in data that date to the 1970s. But that’s no longer an objective. The new mandate the Bank of Canada received from Freeland this week encourages central bankers to seek full employment, but such “probing” will be done only when inflation is moderate. That’s not the case now.
Higher interest rates can achieve that goal, although the transition isn’t always smooth. Back in 2003, the Bank of Canada ended up cutting interest rates almost as fast as it had raised them. The value of the dollar jumped, hurting exporters, while the SARS outbreak disrupted the tourism and hospitality industries. A massive power blackout in Ontario disabled the country’s biggest economic engine, and forest fires raged across Western Canada. The central bank cut its benchmark rate by a quarter point in both July and September, dropping it back to where it was at the start of the year.
“Both inflation and inflation expectations have declined more rapidly than the bank had expected,” policy-makers said back then.
There is a chance Macklem is about to make a similar policy mistake. Charles St-Arnaud, a former Bank of Canada staffer who is now chief economist at Alberta Central, thinks central banks risk stalling the recovery by overreacting to things over which they have little influence. But Macklem has decided he’d rather try to reignite the recovery than lose control of prices.
Inflation expectations “need to be ratified,” he said. “We need to bring inflation back to target to keep those expectations well anchored.”