The economy is slowing. Housing prices are in free fall. Many fear a recession next year. Consumer price growth is easing. Yet the Bank of Canada is still raising interest rates aggressively, with last week’s half-point hike the sixth successive outsized move. Average people are wondering if it’s necessary, whether prior rate increases were enough. Why the heavy foot on the brake pedal?
Economy
Why the Bank of Canada’s Interest rate hike is exactly what the economy needs
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It tastes awful, but it works. Let’s just hope the side effects are minimal
I’m part of a dying species — the generation that actually experienced our last inflationary bout. As kids in grade school, we talked about sky-high oil prices, food shortages, running out of this and that, out-of-control inflation and leaders madly scrambling for solutions. The 1970s spilled into the 1980s, and despite much effort, the inflation beast remained untamed.
Initially, central banks waved it off, expecting that bottlenecks would be temporary and that prices would soon calm down. Clearly, that didn’t happen. In fact, as the weeks passed, inflation’s reach rapidly spread to a much wider range of goods and services; it was no longer just the volatile, non-core elements of the price indexes that were misbehaving. It gets particularly complicated when goods that are used in just about everything are in short supply. Back in the 70s, the high intensity of oil use in the economy saw energy price increases spread everywhere. Intensity is much lower now, so oil isn’t as influential as before. But what about semiconductors? They may be a small part of the cost of final products, but they are in just about everything. Cut off the supply, and suddenly shortages are widespread.
It doesn’t stop here. With prices riding well ahead of wages, employees at all levels get antsy — especially at annual review time. Given record-low unemployment and our current paucity of skilled workers, businesses aren’t in a strong bargaining position. Fail to meet expectations, and turnover could soar. Meet expectations, and you could be out of business. One way or another, a jump in wage growth is almost impossible to resist. That’s when demand-pull inflation turns into cost-push inflation — a much harder beast to tame, as wage-price spirals can set in.
The dynamics of pricing haven’t changed over time. But we haven’t seen them for so long that we likely forgot how they work: that it’s not so much prices, but price expectations, that matter. And that reining them in requires heavy monetary medicine. It tastes awful, but it works. Let’s just hope the side effects are minimal.
Peter Hall is chief executive of Econosphere Inc. and a former chief economist at Export Development Canada.
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Bank of Canada governor Tiff Macklem says that although a slowing economy may not seem like a good thing, it is when the economy is overheated.
Speaking in Quebec City on Tuesday, Macklem said that higher interest rates are working to cool the economy as elevated borrowing costs are constraining spending on big-ticket items such as vehicles, furniture and appliances.
As demand for goods and services falls, Macklem says the economy will continue to slow.
“That doesn’t sound like a good thing, but when the economy is overheated, it is,” he said.
In addition to global events, the overheated domestic economy pushed up prices rapidly, he said.
To slow the economy domestically, the Bank of Canada has embarked on one of the fastest monetary policy tightening cycles in its history. It has hiked its key interest rate eight consecutive times since March, bringing it from near-zero to 4.5 per cent.
However, last month, the Bank of Canada said it will take a “conditional” pause to assess the effects of higher interest rates on the economy.
“Typically, we don’t see the full effects of changes in our overnight rate for 18 to 24 months,” Macklem said on Tuesday.
“In other words, we shouldn’t keep raising rates until inflation is back to two per cent.”
However, the governor said the Bank of Canada will be ready to raise rates further if inflation proves to be more stubborn than expected.
The Bank of Canada is raising interest rates again, bumping it to 4.5 per cent. This marks the eighth increase in less than a year, leaving some homeowners scrambling to keep their mortgages.
As gas prices have fallen and supply chains have improved, inflation in Canada has slowed since peaking at 8.1 per cent in the summer. Macklem called this a “welcome development,” but stressed inflation is still too high.
“If new data are broadly in line with our forecast and inflation comes down as predicted, then we won’t need to raise rates further,” Macklem said.
For inflation to get back to two per cent, Macklem said wage growth will have to slow, along with other prices.
Wage gains lagging inflation
Wages have been growing rapidly for months but continue to lag the rate of inflation. In December, wages were up 5.1 per cent.
Though annual inflation is still at decades-high levels, economists have been encouraged by a more noticeable slowdown in price growth over recent months.
The Bank of Canada forecasts the annual inflation rate will fall to three per cent by mid-year and to two per cent in 2024.
Royce Mendes, an economist with Desjardins, said that Macklem is crossing his fingers that the rate hikes he has implemented so far will be enough to get it done.
“The head of the Bank of Canada seems quite comfortable sitting on the sidelines even as his U.S. counterpart will be discussing the need for further monetary tightening south of the border,” Mendes said.
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