The Bank of Canada wasn’t supposed to be hiking interest rates this summer. Back in January, Governor Tiff Macklem and his team paused their monetary policy tightening, presuming that the barrage of rate hikes over the previous year would be enough to curb economic activity and bring inflation back under control.
That “conditional pause” lasted only two rate decisions. The bank restarted rate hikes in June and moved again this week, raising its key interest rate to 5 per cent, the highest level since April, 2001.
“It’s working,” Mr. Macklem said in an exclusive interview with The Globe and Mail on Wednesday, several hours after raising borrowing costs for the 10th time in a year and a half. “But it’s not working as quickly or as powerfully as we thought it would.”
The Bank of Canada, like many central banks around the world, is contending with a surprisingly resilient economy and stubborn inflation – two sides of the same coin. So far, consumers, employers and homebuyers are proving less sensitive to higher interest rates than previously imagined. That, in turn, means domestic inflationary pressures remain, even as headline consumer price index inflation has fallen rapidly, largely owing to the decline in global oil prices.
Economic resilience is a mixed bag for Canadians. Forecasts of an imminent recession have been pushed back or cancelled altogether, raising the tantalizing possibility of a “soft landing,” where inflation falls back to the bank’s 2-per-cent target without an economic contraction or large spike in unemployment. But it also means interest rates have continued marching higher, squeezing mortgage holders and other borrowers and increasing risks to financial stability.
The Globe spoke with Mr. Macklem about why the economy and inflation aren’t evolving as he expected, what that means for the trajectory of interest rates and whether governments could be doing more to help the central bank in its fight against inflation.
I think it’s fair to say that you, and most central bankers, have been surprised by what’s happened in the past six months with the persistence of inflation and economic growth. What’s going on?
Tiff Macklem: At one level, what’s happening is not too surprising. The economy goes into an unprecedented pandemic, economy is locked down. Economy reopens, and I think really the burst of inflation was unavoidable. … People want to get back to buying the goods and services they enjoyed, they want to catch up. At the same time, companies are having a hard time with supply chains, hiring enough people to do it.
Monetary policy is working. Inflation has come down a lot. It was 8.1 per cent last summer, it’s 3.4 per cent now, and we think it’s going to be around 3 per cent going forward. So it’s working. But we have been surprised by the ongoing strength in demand in the economy and persistence of underlying inflationary pressures.
Labour markets have eased a bit but remain very tight. And households have accumulated what we sometimes call extra savings. I’m sure households don’t see it that way, but they accumulated more savings during the pandemic, and that may be supporting more consumption going forward. So those are elements that are common across a lot of countries.
In Canada, we also have the added dimension that we have strong levels of immigration. … That’s actually helping to ease some of the pressures in the labour market, but it is at the same time adding demand to the economy, because those new entrants into Canada, they’re new consumers, they rent apartments, they buy houses, they go shopping like the rest of us.
How important has the extension of amortization periods that banks have given a lot of their mortgage clients been? And has that disrupted the transmission of monetary policy?
TM: On the margin that may be having a little bit of an effect. But frankly, this is what banks always do. When they’ve got borrowers that are really squeezed or distressed, they work with those borrowers and try to find a solution that works for the borrowers and for the bank.
So this isn’t a new thing. And from our perspective, those households that are financially stressed, that are having real trouble making their payments, they’re not the ones that are going shopping. They’re not the ones that are adding to demand.
Does anyone at this point really understand how inflation is working and how monetary policy is working?
TM: At a high level, things are playing out more or less as we expected. We’ve raised rates a lot, the demand for interest-sensitive items slowed, inflationary pressures are receding.
And the fact that central banks did this around the world is helpful, because by all raising interest rates on a roughly similar schedule, collectively we’ve kept inflation expectations well anchored, we’ve moderated the demand for globally traded goods. That’s helping all of us. Services in our economies are more affected by domestic demand, and that’s where the interest-rate increases in Canada are moderating.
So it’s working. But it’s not working as quickly or as powerfully as we thought it would. There, I think, there’s some question. It’s been a long time since we raised interest rates this much. So has something changed in the monetary policy transmission mechanism? Maybe. I think the more likely explanation is the forces that we’re working against are stronger. … Households have more accumulated savings. The tightness of labour markets. The growth in the population. Those things are all adding to demand. So there’s more work to be done.
Do you think the pause in January was a mistake?
TM: I think the pause in January made sense. Frankly, I think it was a prudent thing to do when you’re trying to balance the risks of over- and undertightening. The second thing I’ll say is a pause is a pause. We didn’t say we were done. In fact, we were very clear: If we need to do more to get inflation back to the 2-per-cent target, we will.
The situation in January is we had raised rates from ultralow levels to 4.5 per cent in the space of 11 months. It was the fastest increase in interest rates in the Bank of Canada’s history. It only made sense to pause and see what the impact of that very rapid increase in interest rates would be on the economy.
Was there a moment where you looked at your terminal, or a piece of data came out, and that was the red light that suggested things were way too strong?
TM: I know everybody would love: ‘There’s one thing, that’s what we follow, and that’s the shining bright light.’ But that’s not the way it really works. It’s the accumulation – and I would stress, the consistency – across the indicators.
When you start to see demand is stronger, consumer spending is stronger, housing is coming back, the labour market is still tight, underlying inflationary pressures are stronger than expected, the downward momentum in inflation is easing. When those things are all pointing in the same direction, you need to do some more.
The Bank of Canada’s new forecast for GDP growth is considerably stronger and shows that it’s going to take longer to get back to the inflation target. Does that mean that rates need to go higher? Or simply that they need to stay high for a longer period of time?
TM: We’re going to take those decisions one at a time as we move forward. … With the increases in the policy rate in June and July, our forecast has inflation hovering around 3 per cent for the next year and then gradually moving back to the 2-per-cent target. So what that suggests is that we’re close.
But as I underlined, there are a number of things that have to happen for that easing in inflation to happen. … Excess demand in the economy needs to diminish, the economy needs to come into better balance, and in our forecast we have the economy moving into modest excess supply next year. … We need to see a better balance in the labour market and we need to see wage growth moderate.
Corporate pricing behaviour: What we’ve seen through this period of high inflation is companies are increasing their prices much more frequently – and by more. We’ve started to see that normalize – the size and the frequency have both come down a bit. But we need to see that process of normalization continue.
Expected inflation: That’s come down. But if you look at our own surveys of households and businesses, yes, their near-term expectations for inflation have come down, but they’re still higher than our own forecast. … They need to keep coming down. And of course we’re going to be watching the dynamics of inflation itself.
In a press conference in May, you said Canadians should not expect interest rates to come down to the low levels we saw before the pandemic. Is the era of low interest rates over?
TM: We have different models we use to estimate the neutral rate [the central bank’s estimate of where its policy rate would settle if the bank were neither trying to stimulate nor restraining the economy]. … Those models, based on the data we have, still suggest a neutral rate in the range of 2 to 3 per cent.
When we look forward, and we look at a number of the forces, it seems more likely that the neutral rate is going to be higher than that … [rather] than lower than that. We don’t have that data yet. But there are a number of factors.
More people are retiring. The labour market looks like it could be sort of structurally tighter going forward. Globalization has at least stalled, if not reversed. That could create more cost pressures. We’re going to need a lot of new investment in cleaner technologies if we’re going to meet our emissions-reduction targets. When I say ‘we,’ it’s the world – so that’s going to affect global real interest rates.
So when you look forward, it seems more likely that the neutral rate is higher, not lower. And the message is that households, businesses, governments, the financial system, they need to be prepared for that possibility.
How worried are you about getting out to 2025, 2026, when you start seeing all these mortgages that had their amortization periods extended snap back to their original payment schedules?
TM: We know that there are more effects to come from the interest-rate increases we’ve already done. We’ve built those into our models, but there’s always some uncertainty about how much effect it will have.
How will that affect households? Look, for some households, it is going to be difficult. But for many households, they will have built up more equity in their home. They probably will have gotten a raise over that period, their incomes will be higher. Our sense is that as long as the job market is healthy, people have got jobs, it will certainly squeeze people’s budgets, but most people will be able to manage that.
The risk from a Canadian perspective is if there was a global recession, if Canada goes into a recession, unemployment does go up. That will make it much more difficult when people have to reset their mortgage. And we are a more highly indebted country, and that could amplify that pain.
That’s not something we have in our forecast. Our forecast, which we think is the most likely scenario going forward, we actually have inflation coming down to target with modest positive growth for the next year, and then growth actually picks up. … But particularly when you’re thinking about financial stability issues, you have to think about what are the tail risks? What are the things that could go wrong? And how do you plan for those?
The Bank of Canada has been doing the majority of the heavy lifting on controlling inflation. Is there more that fiscal policy – government spending and taxation – should be doing to take some of that pressure off your shoulders?
TM: The reason you have an independent central bank is so that they can take the difficult decisions, and you’ve got an independent body that is committed to restoring price stability for Canadians. We’re going to leave decisions for fiscal policy to elected officials – that’s really where they properly lie.
Yes, government spending continues to grow. We take government spending and government policies as given. We build those into our forecast. You can see in our forecast that government spending is growing at roughly 2 per cent.
So yes, governments are contributing to demand in the economy. Government spending is growing roughly in line with the growth in the [economy’s] potential. So yes, I think it’s fair to say governments aren’t helping the disinflation process. But they’re not really in serious conflict with monetary policy, in the sense that they’re not the major factor that is making it more difficult to get inflation back to target.
Do housing prices need to come down to hit the inflation target?
TM: We don’t target housing prices. We don’t target the housing market. The housing market is an important part of the economy, but there’s a lot of other parts of the economy, and we really have to look at the whole thing.
The fundamental issue in the housing market, and this has been an issue in Canada for 10 years, at least, is structurally the demand for housing is growing faster than the supply. And so yes, interest rates go up, the housing market will slow. But it’s only going to slow so much because there is a sort of structural shortage of supply relative to demand.
I think what you’re seeing is that with supply growing less than demand, the housing market has started to tick back up, housing prices have started to tick back up. That’s something we need to take into account in monetary policy. But we’re not targeting the housing market. We have one target: CPI inflation.
What does summer vacation look like? Do you get to now relax and kick back?
TM: Next stop, Friday I take off for India, there’s a G20 meeting. … Looking beyond that, yes, I am hoping to take some time off. We’re fortunate enough to have a summer cabin, summer cottage, and I’m hoping to spend a bit of time up there. Relax. Go for a swim. Do some canoeing.
White water canoeing?
TM: No white water. I have enough excitement in my life. Just flat water.
This interview has been edited for length and clarity.