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June 6, 2022

From: William B.P. Robson

To: Canadians Concerned about Inflation and the Bank of Canada

Date: June 6, 2022

Re: Lower Inflation is Key to Ending Controversy over the Bank of Canada

For the first time in years, the Bank of Canada is under attack.

Before the COVID-19 pandemic, the Bank kept inflation well under control – remarkably close to its 2-percent target – for more than 25 years. Since early 2020, however, inflation has surged. Consumer prices are up almost 7 percent year-over-year. People are angry, and politics reflects their anger. The answer is simple: The Bank must get inflation back down.

Some of the attacks are personal; promises to fire Governor Tiff Macklem have made recent headlines.

That does not help.

Partly because it tempts the Bank’s defenders to respond in kind – to denigrate the attackers or dismiss people’s anger about inflation. Those responses only make a bad situation worse.

People hate inflation for good reasons. They get monthly, even daily, reminders that prices of food, energy, housing – the necessities of life – are rising faster than their paycheques. Debasement of the currency is not something they can control. It is unsettling – even frightening – when the stability in money’s value that lets people budget, bargain and plan for retirement disappears.

And inflation is divisive: while a minority of Canadians, such as federal government employees with indexed pensions, can get protection from it, most people cannot. They feel their lack of protection, and they understandably resent it.

That is why, after the high-inflation 1970s and 1980s, the Bank of Canada reduced inflation, and the elected federal government of the day agreed on inflation targets to keep it low. Until recently, we did not have this problem, and we forgot how corrosive – and politically explosive – inflation is.

So the Bank of Canada must lower it. To do that, it needs to raise short-term interest rates and shrink its balance sheet.

The interest-rate task is familiar and, so far, less controversial. When the Bank of Canada floods the financial system with cash, as it did at the start of the pandemic, the cost of funds to banks and their customers falls. That stimulates growth of credit and money, which in turn stimulates spending. The Bank is moving on interest rates. Its target for the overnight rate, which was 0.25 percent for almost two years, stands at 1.5 percent after last week’s increase, and the Bank has signalled that it will rise farther.

The balance-sheet task is less familiar and has already proved controversial. When the pandemic started, the Bank decided its normal operations aimed at very short-term interest rates would not be enough. So it turned to quantitative easing: buying bonds, especially federal government bonds, and in large amounts. Quantitative easing reduced worries that COVID-19 would trigger a financial crisis, and pushed more cash into the financial system, further stimulating growth of credit, money and spending. There, too, the bank has changed course. It is not buying any more bonds, and has announced that its existing holdings will decline as the bonds mature.

With inflation running at 6.8 percent in April, however, this passive shrinking of the Bank’s balance sheet as the bonds mature strikes some observers as inadequate. At the most recent meeting of the C.D. Howe Institute’s Monetary Policy Council, eight of nine members urged the Bank to accelerate the process by selling bonds.

The Bank’s own analysis suggests that its buying did not affect the bond market much, and if that is true, the market should be able to take selling in stride. Moreover, selling the bonds would address head-on one especially damaging line of criticism – that the Bank’s bond purchases financed the federal deficit, making it an ATM for the government – and make even more explicit to Canadians that inflation control comes first.

The Bank’s hikes in its target for the overnight rate will get more controversial in time; people dislike inflation, but they also dislike rising interest rates on mortgages and loans. At the moment, however, an overnight rate around 1.5 percent and an inflation rate that’s close to 7 percent makes interest rates way negative in real terms. That prefigures fast growth of credit, money and spending, and continued inflation.

The stakes are rising. As long as inflation stays high, people will be angry, and political attacks on the Bank of Canada will continue. An especially bleak but realistic scenario is that attacks on the Bank’s integrity and independence mount even as tighter monetary policy starts to pinch, provoking fears that political interference will undermine inflation targeting altogether – with the perverse result that inflation stays higher for longer.

The Bank of Canada itself can do much to prevent that outcome by acting aggressively over the coming months. The best way to address the anger and the attacks is to get inflation down.

William B.P. Robson is the CEO of the C.D. Howe Institute.

To send a comment or leave feedback, email us at blog@cdhowe.org.

The views expressed here are those of the author. The C.D. Howe Institute does not take corporate positions on policy matters.

An earlier version of this Memo first appeared in The Globe and Mail.