The Bank of Canada may have to be “forceful” in pushing back against high inflation, deputy governor Timothy Lane said in a Wednesday speech that aimed to explain the central bank’s forecasting errors over the past two years and set the stage for a rapid rise in interest rates.
With the rate of inflation at a 30-year high, the bank ended its last emergency monetary policy measure in January and signalled it expects to start raising its key interest rate shortly.
In a rare moment of indiscretion for a central banker, Mr. Lane appeared to suggest the bank had already decided to increase rates on March 2, its next policy announcement date – underscoring what most economists already consider inevitable.
In response to a question about the massive number of government bonds the bank accumulated in the first year and a half of the pandemic, he said the governing council would think about reducing these holdings after the first rate hike.
“Quite likely, we’ll be saying something about that in a couple of weeks time when we’re actually at the stage of changing our ... uhh, when we’re actually at our next decision point,” Mr. Lane said.
After the speech, Bank of Canada spokesperson Paul Badertscher said the governing council has not yet decided what the coming rate announcement will be. “Decisions are taken at the end of governing council’s deliberations, and the deliberations for the March 2 announcement have not yet happened,” he said in a statement.
The pace of rate increases, and how high the bank’s overnight rate ultimately goes, will depend on the trajectory of inflation this year. Market-based indicators show investors expect at least six rate hikes this year. The bank has held its policy rate at 0.25 per cent, as low as it can go, since March, 2020, to encourage borrowing and support the economic recovery.
On Wednesday, Statistics Canada reported the annual rate of growth in the consumer price index hit 5.1 per cent in January. The Bank of Canada has forecast the inflation rate will remain close to 5 per cent until the middle of the year.
Mr. Lane said the central bank expects inflation to decline quickly in the second half of the year, but he added the policy makers are “alert to the risk” that high inflation could prove more persistent.
“We will be nimble – and if necessary, forceful – in using our monetary policy tools to address whatever situation arises,” Mr. Lane said in the virtual address to the University of Calgary’s school of public policy.
Royce Mendes, head of macro strategy at Desjardins, said the hawkish tone of the speech will raise questions about whether the central bank will start with a 0.5-per-cent rate increase, although he still expects a hike of 0.25-per-cent in March.
“The Bank of Canada is less worried about current inflation and more concerned about inflation expectations,” Mr. Mendes wrote in a note to clients. “A strong commitment to do what’s necessary, even if it’s painful, should work to keep expectations anchored, and hopefully make it less likely that the Bank of Canada will need to actually use such a heavy hand.”
Much of Mr. Lane’s speech was dedicated to explaining the central bank’s policy response to the COVID-19 pandemic and outlining the reasons its economic forecasts have consistently underestimated inflation.
The Bank of Canada, like other central banks around the world, was caught flat-footed in the fall of 2021 by the strength and persistence of the growth in consumer prices. This situation has prompted a major rebalancing of monetary policy in recent months, with central banks winding down emergency response measures, such as massive purchases of government bonds, and starting to increase interest rates much sooner than expected.
“The recession Canada faced was nothing like a textbook case, and there was exceptional uncertainty about how it would play out,” Mr. Lane said.
At the outset of the pandemic, the bank’s main worry was that the sudden spike in unemployment and drop in economic activity would drive inflation below zero and kick off deflation, something that worries central bankers as much as inflation.
As the economy began to recover, Bank of Canada economists expected supply in the economy to come back faster than demand. This assumption proved to be incorrect, leading them to underestimate the factors pushing up consumer prices.
“There are several ways in which supply and demand behaved differently than we expected,” Mr. Lane said. “For one thing, vaccines were developed and deployed in record time, a little more than a year after the pandemic first began and one year sooner than we originally assumed.
“In addition, we underestimated the ability of businesses and workers to adapt to the pandemic and learn how to work around it in innovative ways. This period is marked by accelerated growth in all aspects of the digital economy,” he said.
Central bank economists were also surprised by the dramatic shift in consumer spending from services to durable goods, Mr. Lane said. This surge in demand for manufactured products coincided with supply chain disruptions caused by factory shutdowns, transportation delays and shortages of key materials, curtailing supply and pushing up prices.
While the economic picture has not evolved in line with the bank’s projections, Mr. Lane said policy makers have been able to adjust to changing circumstances and will continue to do so.
“Turbulent times call for openness to new facts and ideas and agility in decision-making. Uncertainty may require a cautious and gradual approach when entering uncharted territory – but as the pandemic has illustrated, there are times when policy makers must act boldly,” he said.
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