Bank of Canada Governor Tiff Macklem is standing by his assertion that the current bout of high inflation is transitory, even as top Canadian bank executives question that narrative and warn that price pressures could persist.
Mr. Macklem said on Thursday that high inflation will likely recede once global supply chains normalize. But supply bottlenecks “are looking to be more complicated, more persistent than we previously thought,” and the rate of inflation may take longer than previously expected to come back down, he told a news conference in Washington, where he is attending meetings of the International Monetary Fund and the World Bank.
One reason bank executives and central bankers disagree over what will happen with inflation is that they have different expectations when it comes to a key point of financial uncertainty. Namely, how rapidly Canadians will spend the hundreds of billions of dollars of excess savings built up over the course of the pandemic, when lockdowns temporarily made it easier to put money away because there were fewer things to spend it on.
The central bank has conservatively estimated Canadians will spend around 20 per cent of their pandemic savings over the next few years. But the bank executives think Canadians will spend much more than that as life begins to return to normal. An unusually high level of spending could lead to higher inflation.
The central bank’s policy is to keep the annual rate of consumer price index growth between 1 per cent and 3 per cent, but price increases have run above that target band since April, hitting an 18-year high of 4.1 per cent in August. The IMF said this week that it expects high inflation to decline in most advanced economies by the middle of next year, but warned central banks need to be prepared to react quickly if supply-chain bottlenecks cause inflation expectations to become unanchored and wages to spiral upwards.
Royal Bank of Canada chief executive officer Dave McKay said at a virtual event hosted by the Institute of International Finance on Wednesday that persistent inflation is building, and that there is “a big disagreement” between some CEOs and central bankers over the probable path of consumer price growth.
National Bank of Canada CEO Louis Vachon echoed Mr. McKay’s concerns in an interview on Thursday. When COVID-19 recedes as the primary threat to the global economy, inflation is “going to become the No. 1 macro issue very quickly,” he said.
So far, data on household spending are largely in line with the central bank’s forecast, Mr. Macklem told reporters. But he acknowledged there is considerable upside risk to the bank’s prediction if consumers continue to spend heavily on durable goods at the same time they start spending more on pandemic-restricted services such as restaurants and travel.
“If we start making big forecast errors, well that would be a signal that we need to take a hard look at that. But so far that hasn’t happened,” he said.
Bank executives have raised concerns that longer-term forces could push up inflation, even as temporary supply-chain problems are worked out over the coming year.
Mr. Vachon said the demographics of an aging population, combined with lower immigration levels in recent years, have reduced the supply of labour. “I don’t think that you can turn that around in six months,” he said. And although the pandemic’s short-term effects on supply will eventually ease, he added, “geopolitics is another thing that’s redrawing supply chains in real time right now. That is more permanent.”
He also cautioned the fight against climate change could be inflationary, as it will require massive investments in lowering carbon emissions and is likely to drive some energy prices higher.
On Wednesday, Mr. McKay made a similar point. “Climate’s having an impact on supply chains,” he said, citing its effects on agricultural crops, such as canola in Canada and rubber in Thailand.
Mr. Vachon said while he disagrees with the Bank of Canada’s inflation outlook, he is even more concerned about the direction of the central bank’s American counterpart, the U.S. Federal Reserve.
“I think the Bank of Canada is giving themselves more flexibility than the Fed,” he said. “I think the concern in the industry is … more the Fed position: That dual mandate that they’ve put in place, and how dovish they were earlier in the year on inflation.”
The Fed’s dual mandate means it seeks to hit both an inflation target and full employment. In the summer of 2020, it adopted a new average inflation targeting model that seeks to make up for periods of low price growth by aiming for above-target inflation while the United States is coming out of recessions. The Fed also changed its definition of full employment to put more emphasis on labour-market inclusion. This makes U.S. monetary policy more likely to maintain low interest rates for longer periods of time than has been the case coming out of previous recessions.
So far, the Fed has held off on reducing the size of its quantitative easing (QE) program, in which it buys benchmark government bonds to try to bring down long-term interest rates and push up inflation – although chair Jerome Powell has signalled the Fed may begin to taper its bond purchases later this year. By contrast, the Bank of Canada began reducing the size of its QE program a year ago, and is now buying around $2-billion worth of government bonds a week, down from $5-billion at the start of the pandemic.
Analysts widely expect the Bank of Canada will further cut its bond purchases at its next rate decision on Oct 27. This would see the bank move into what it calls a “reinvestment phase,” where it is keeping the size of its balance sheet steady but no longer expanding it.
As central bankers and CEOs try to forecast the path of inflation, all eyes are on two indicators: inflation expectations and wages. Mr. Macklem said the rate of inflation expected in the short term by businesses and consumers has increased, but medium and long-term expectations remain well anchored near the bank’s inflation target. As for wages, “they have picked up a little bit, but they’re not providing any independent source of inflation,” he said.
Mr. Vachon has a different view of the situation: “When we look at wage inflation right now, it’s quite real. And again, when we look at demographics and so forth, at least for the immediate future, I don’t see how that can be transitory,” he said.
He added that his concern stems from his memories of sky-high interest rates in the 1970s and the risk that “the evil genie of inflationary expectations gets out of the bottle and it becomes a real tough exercise to put it back in the bottle.”
The Bank of Canada has kept a lid on inflation expectations since the early 1990s, and Mr. Macklem said the bank is willing to do what is needed if inflation becomes more persistent and inflation expectations start to shift higher.
“We think there’s good reasons to believe that these are one-off price increases, they won’t create ongoing inflation. But if that’s not the case, yes, it is our job to take action and bring inflation back to target and we’ll do that,” Mr. Macklem said.
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