Bank of Canada Governor Tiff Macklem said the central bank could be aggressive in pushing up borrowing costs this year, as inflationary pressures broaden and commodity prices move sharply higher in response to Russia’s invasion of Ukraine.
In a virtual speech to the CFA Society of Canada on Thursday, Mr. Macklem said the central bank has “considerable space” to raise interest rates this year. He added that he is not ruling out a half-percentage-point rate hike at a coming meeting, rather than the typical quarter of a point – something that hasn’t happened since May, 2000.
On Wednesday, the central bank raised its policy interest rate to 0.5 per cent from 0.25 per cent. This was its first rate hike since 2018, and the first move in what is expected to be a rapid succession of interest rate increases that could bring borrowing costs back to prepandemic levels some time next year.
Mr. Macklem said some Canadians could be squeezed by rising interest rates. But he said higher borrowing costs are needed to prevent inflation expectations from becoming unmoored, and to ensure demand in the economy doesn’t outstrip supply, further pushing up consumer prices.
“For households and businesses that are already feeling the pinch of inflation, the higher cost of borrowing can be doubly painful. But tighter monetary policy is necessary to lower the parts of inflation that are driven by domestic demand,” he said.
The war in Ukraine is adding to inflationary pressures, as sanctions and supply disruptions send global commodity prices sharply higher. The price of a barrel of West Texas Intermediate crude oil, for instance, was trading around US$110 on Thursday – a price last seen in 2014.
“These higher prices are going to impact Canadians fairly quickly. They’re going to see it fairly quickly at the gas pump, they may start to see it in the grocery store. That’s going to hit them right in the pocketbook,” Mr. Macklem said.
If the price of oil stays around US$110, that could add around a percentage point to inflation this year, he said. On the flip side, higher energy and other commodity prices tend to benefit Canada’s export-oriented economy. That means the central bank will need to balance the positive and negative effects of the commodity price shock when setting monetary policy.
The bank’s decision to raise interest rates on Wednesday was driven by two factors. The Canadian economy has largely recovered from the pandemic-related recession and no longer needs emergency support. At the same time, consumer prices are growing at the fastest pace in decades, eroding the purchasing power of the Canadian dollar and straining the credibility of the central bank. The annual rate of consumer price index growth hit a three-decade high of 5.1 per cent in January.
Mr. Macklem highlighted the fact that the economic recovery was progressing better than the bank expected, even through the latest wave of COVID-19. But his comments focused mainly on inflation. He noted with concern that price increases have been broadening in recent months. Two-thirds of the 165 components that make up the consumer price index experienced inflation above 3 per cent in January.
“It is making it more difficult for Canadians to avoid inflation, no matter how patient or prudent they are as shoppers,” he said.
The big worry for the Bank of Canada is that continuing high inflation could cause inflation expectations to become unmoored. Central bankers care about expectations because where people believe inflation is headed has a significant impact on where consumer prices end up.
“What we’ve learned from history is that the economy just does not work well when inflation expectations become unmoored,” Mr. Macklem said, noting the economic strife of the 1970s, when people did not trust the central bank to stabilize the value of money.
“Everybody felt like they were getting ripped off, because they’d get their paycheque, but prices would go up. There was a lot of strikes, there was a lot of labour strife, because workers always felt like their wages weren’t keeping up with inflation,” he said.
If people start expecting inflation considerably above the Bank of Canada’s 2-per-cent target, the bank would have to push interest rates much higher to get consumer price increases back under control.
Some of the factors driving inflation could start to decline this year as the pandemic recedes, Mr. Macklem said. He noted that there are signs that global shipping costs are coming down and manufacturers are having an easier time sourcing key inputs. At the same time, he warned that it is difficult to predict how long it will take for supply chains to normalize, and said the war in Ukraine has complicated the picture.
Domestic sources of inflation caused by demand exceeding supply have not yet become a major factor pushing up consumer prices, Mr. Macklem said. But he cautioned that this could become an issue going forward if the central bank does not step in to tamp down demand.
“With slack absorbed and considerable momentum in demand, we need higher interest rates to dampen spending growth so that demand does not run significantly ahead of supply,” he said.
“Raising the policy rate will not fix supply chain disruptions, nor will it lower oil prices. What monetary policy can do is make borrowing more expensive, which slows domestic demand.”
The bank’s main tool for bringing inflation back to its 2-per-cent target is its overnight policy rate. But the bank will also be tightening policy by shrinking the size of its balance sheet. The bank’s holdings ballooned over the past two years as it bought hundreds of billions of dollars worth of federal government bonds as part of its quantitative easing program.
Mr. Macklem said the bank does not intend to sell those bonds, but that it will start letting them mature and roll off the balance sheet some time in the near future.
“Roughly 40 per cent of our bond holdings mature within the next two years. This suggests that, other things being equal, our balance sheet would shrink relatively quickly,” he said.
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