In a surprise move, the Bank of Canada kept its overnight rate target steady at 25 basis points Wednesday. Markets had already priced in a rate increase by the time the announcement was made, so there was ample cover to make this the first post-pandemic increase. That didn’t happen. With inflation rising at home and abroad, we believe this was a missed opportunity.
Steady increases in inflation and inflation expectations had led markets to believe the bank was set to increase its target for the overnight rate for the first time since the pandemic began. Headline inflation was up to 4.8 per cent in December, all of the bank’s core inflation measures had increased — with two of the three at or above three per cent — and its December Business Outlook Survey revealed that two-thirds of firms expect inflation to remain above three per cent for the next two years.
The bank’s view that recent high inflation readings were temporary has evolved as inflation has crept upwards. And continued government spending — justified in the early pandemic days, harder to justify today — has added an unhelpful push to prices, with overall spending now outpacing our current production capacity.
Unfortunately, the same policy decisions have been made abroad, leading to the same inflationary response. Australia had 3.5 per cent inflation in December, the Euro area 5.0 per cent; the U.K. 5.4 per cent and the U.S. a whopping 7.0 per cent. In each country, headline inflation was up from November. Yes, inflation is a worldwide phenomenon — but mainly because almost all countries are following the same inflationary policies.
With prices continuing their rise, however, the world’s central banks have become significantly more hawkish on inflation. The Bank of England raised its policy rate in December for the first time since the beginning of the pandemic (albeit to only 25 basis points). The Federal Reserve has said it will begin raising its policy rate in March and will start to trim its balance sheet.
In the long run, the inflation rate in any economy with a flexible exchange rate is determined by that country’s own monetary policy. On the other hand, inflation abroad can exacerbate the difficulties we face taming prices at home.
Before the pandemic, Canada’s inflation rate had remained chronically below the two per cent target. Explanations for this phenomenon abound. The bank’s own research has identified low world inflation as one of the main causes for the bank’s difficulties in hitting its target, the reason being that global inflation is driven largely by energy and food prices, which make up a big part of Canada’s typical consumer market basket. This remains true today, as anyone who has filled up their gas tank recently or taken a trip to the grocery store can attest.
Unhelpful shifts in global demography may also lead to continued increased prices at home. In their 2020 book The Great Demographic Reversal, Charles Goodhart and Manoj Pradhan convincingly explained how temporary demographic factors had biased world inflation downward in recent years. The integration of China and Eastern Europe into the world economy and migration within China from rural areas to coastal cities had together led to the largest increase in labour supply in history. The resulting labour glut lowered production costs for most manufactured goods. But the world’s population is aging and growth in its working-age population is rapidly slowing, which increases production costs. On top of huge monetary and fiscal responses to the pandemic all over the world, these changes have led and will continue to lead to higher inflation and that inevitably will push interest rates up.
Higher global inflation will also make it harder for the Bank of Canada to bring down Canadian prices. Our very open economy relies on imports of both final and intermediate goods. Higher prices abroad will soon mean higher prices here.
Interest rate hikes are coming. The bank’s announcement this week said as much. With the Fed also beginning to act, most advanced-economy central banks are likely to start tightening their monetary policies. If they succeed, that will help moderate what Canadians pay for imports. Its effect on global demand is less certain. Higher interest rates are likely to slow global consumption.
This is one of the many problems with an inflation fever; if it takes hold, it is hard to break. Yes, interest rate medicine can be hard to swallow, as the Bank of Canada has shown this week, but it doesn’t go down any easier if you put off taking it.
Steve Ambler, a Professor of Economics at the Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, where Jeremy Kronick is Associate Director, Research.
Published in the Financial Post