The Bank of Canada says it consistently underestimated the trajectory of inflation over the past year as a result of unexpected increases in global commodity prices and shifting patterns of consumer spending that it failed to account for fully.
This misreading of inflation means it has to play catch-up, pushing interest rates aggressively higher and increasing the cost of borrowing to prevent consumer prices from spiralling out of control. It announced a rate increase of a full percentage point this week, the biggest move since 1998.
In their quarterly Monetary Policy Report released alongside the rate increase, Bank of Canada economists lay most of the blame on the fact that the price of commodities, notably oil, behaved far differently over the past year than they predicted. They also say that they underestimated the shift in consumer demand toward goods and away from services during periods of lockdown, as well as the speed with which the Canadian economy would rebound after subsequent waves of COVID-19 infections.
However, some analysts point to other factors, such as a misreading of how low unemployment could go before it triggered inflation, and economic models that were ill-suited to the unusual circumstances of a global economic shutdown.
Errors in forecasting have a major impact on monetary policy. Because changes in interest rates take time to trickle through the economy, central bankers have to adjust their policy based on where they think inflation will be many quarters out. That makes accurate forecasting important.
As the rate of inflation began increasing last year, the Bank of Canada and many other central banks said the situation would be transitory. This influenced the bank’s decision to hold off raising interest rates until early March of this year, by which time the annual growth rate of the consumer price index (CPI) was running at 5.7 per cent. It has since reached 7.7 per cent in May, the highest since 1983.
“If we had known everything a year ago that we know today, yes, we probably would have started raising interest rates a little bit earlier,” Mr. Macklem said.
“But we didn’t know. A year ago, there was still a lot of excess supply in the economy. The unemployment rate was about 7.5 per cent last summer. We were still in the midst of waves of the virus.”
According to the bank’s analysis, about 40 per cent of the deviation between its CPI forecast of April, 2021, and actual CPI inflation in the second quarter of 2022 was the result of unexpectedly high commodity prices. The biggest factor was oil prices, which rebounded in 2021, then surged after Russia invaded Ukraine. Agricultural commodity prices were also higher than expected as a result of drought last summer and the war in Ukraine.
The bank attributed another 20 per cent of its forecasting error to stronger-than-expected goods prices. COVID-19 disrupted global manufacturing and transportation networks, leading to shortages and higher shipping costs. This was compounded by a shift in consumer spending to goods and away from in-person services during lockdowns.
Another 20 per cent of the forecasting miss was chalked up to the faster-than-expected recovery of the Canadian economy after the recession at the beginning of the pandemic. It was a very atypical downturn, the bank noted. Consumer incomes and confidence actually grew during the pandemic, thanks in part to low interest rates and significant support for households and businesses from the federal government.
“The large accumulation of savings, low mortgage rates and changes in homebuyer preferences led to house prices growing by more than had been expected given the amount of slack in the economy,” the bank said in the Monetary Policy Report. “The sharp rise in house prices has boosted consumer price index inflation by 1.2 percentage points on average since the middle of 2021.”
Claire Fan, an economist with the Royal Bank of Canada, noted that many economists struggled with forecasting errors over the past year because their models were developed during a long period of low inflation, and were not calibrated to account for major supply side disruptions like those that occurred during the past two years.
The downturn “was a really unique situation that’s not triggered by underlying fundamental weakness in the economy, but more so by a shutdown that was by design to stop the spread of the pandemic,” Ms. Fan said in an interview. “So in this sort of unique situation, it’s not strange to see models which explicitly used past data to predict the future fail.”
Stéfane Marion, chief economist with National Bank, said the Bank of Canada’s assessment of its own forecasting errors needs to be taken with a grain of salt.
“I think it’s a bit too easy to blame external factors for two-thirds of your miss,” he said in an interview. “There’s a serious lack of transparency when it comes to their analysis of the Canadian labour markets.”
He noted that the bank does not publish its forecast for unemployment, making it hard to gauge how far off it was in assessing labour market tightness. Economists believe runaway inflation in the 1970s was caused in part by incorrect beliefs at central banks about how low unemployment could be before it caused inflation.
“What was your forecast on potential output, and the natural rate of unemployment?” Mr. Marion said. “Unless you show that forecast, how are you supposed to convince me that your inflation miss is based on external factors? You’re not showing me the internal assumptions that were made for the domestic economy.”
The bank published an updated inflation forecast on Wednesday. It now expects the rate of inflation to average 7.2 per cent in 2022 and 4.6 per cent in 2023 – considerably higher than it forecast in April. It does not expect inflation to return to its 2-per-cent target until the end of 2024.
Some economists have said the bank misread the trajectory of inflation because it did not pay close enough attention to the amount of money in circulation. The money supply expanded significantly in 2020, partly as a result of the Bank of Canada’s program to buy federal government bonds, which was used to push interest rates even lower.
The central bank has not focused on the money supply when making monetary policy decisions since the 1980s. In his interview with the Financial Post, Mr. Macklem appeared to dismiss the idea that the bank’s forecasting mistakes were because of inattention to money, which he said was “not always that reliable an indicator” of inflation.
“You definitely want to keep an eye on money, but ultimately what you have to look at is, where is demand in the economy, relative to the economy’s ability to produce the goods and services that people want. And if supply can’t keep up with demand, you’re going to get inflation,” Mr. Macklem said.
Your time is valuable. Have the Top Business Headlines newsletter conveniently delivered to your inbox in the morning or evening. Sign up today.