In late April, Bank of Canada Governor Tiff Macklem appeared before the House of Commons finance committee in Ottawa to answer questions about the central bank’s most recent interest rate decision.
Two weeks earlier, his team had announced the first oversized rate increase in two decades. That half-percentage-point move, the second hike since March, was a major step forward in the central bank’s campaign to get inflation under control.
But it was also a clear attempt to make up for lost time – a tacit admission the bank waited too long to begin increasing borrowing costs and needed to play catch-up.
“We got a lot of things right, we got some things wrong, and we are responding,” Mr. Macklem told parliamentarians in what amounted to his first significant mea culpa as Canada’s top central banker.
The continuing surge in consumer prices has forced central banks to pivot abruptly in recent months from attempting to stimulate the economy to trying to cool it down. It’s also forcing central bankers to do some soul-searching.
The Bank of Canada, like many central banks overseeing advanced economies, was slow to start raising rates, even as it became clear that high inflation was not going to be a temporary blip. That now looks like a costly error. It has dented central bank credibility and forced policy makers to slam on the brakes, upending financial and housing markets and increasing the likelihood of a recession.
“If you had perfect hindsight, you’d go back,” U.S. Federal Reserve chair Jerome Powell said earlier this month, “and it probably would have been better for us to have raised rates a little sooner.”
By the fall of 2021, it seemed apparent the Canadian economy no longer needed emergency-level stimulus and inflation was not going to be transitory. (The word “transitory” had been a kind of talisman held up by central bankers and inflation doves, and it became a hotly debated topic as evidence mounted that inflation was anything but short-lived.)
The Bank of Canada responded in late October by ending its government bond-buying program, known as quantitative easing (QE). But it held off bringing out its strongest tool for combatting inflation through its subsequent meetings in December and January.
So what happened? Why did the Bank of Canada, the Federal Reserve and numerous other central banks hold off raising interest rates until the spring of 2022? The answer, of course, depends on who you ask.
Central bankers tend to point to the challenges of economic forecasting in a time of extreme uncertainty.
Economic models weren’t designed for a global COVID-19 pandemic, in which large segments of the economy closed and reopened multiple times, and patterns of consumption, savings and trade were rewired in real time. Add geopolitical shocks, such as Russia’s invasion of Ukraine, and you have a forecaster’s nightmare.
But there may have been other factors at play. There’s a sense, among sympathizers and critics, that central bankers were fighting past battles. For more than a decade after the 2008-09 financial crisis, the main problem for most central banks was consumer price inflation being too low. That conditioned policy makers to think high inflation was a problem of the past; if it did return, it could be dispatched easily.
“To a degree, you could say that policy makers were hostage to some history,” former Bank of Canada deputy governor John Murray said in an interview. He said he’s sympathetic to the challenges central bankers have faced, “but this has been a reminder that things can change, and change in a hurry.”
Central banks are now in a tight spot. Controlling inflation is much easier if they are credible in the eyes of the public. But they need to get inflation back down to restore that credibility. The key here is inflation expectations: If employees and businesses expect inflation to be high, they’ll demand higher wages and set higher prices, making inflation a self-fulfilling prophecy.
“People look at results. They don’t say, ‘you did the right thing, but it turns out that you made a mistake because of things you didn’t know,’” University of Toronto economics professor Angelo Melino told The Globe and Mail.
That leaves the Bank of Canada with a narrow path forward: putting its shoulder down and pushing interest rates higher in the hope that inflation will come down before people’s inflation expectations become unanchored.
“There’s no good way to do this,” Prof. Melino said. “It’s going to hurt. You can’t get rid of inflation without pain. And the credibility will come from its willingness to take the blame to get things going again.”
When inflation began picking up in the spring of 2021, central bankers shrugged it off. The consumer price index was being pushed up by pandemic-related forces – notably a rebound in oil prices and supply chain problems related to a few goods, such as semiconductors. These issues would dissipate over time, the Bank of Canada said.
In retrospect, this “transitory” inflation narrative looks way off base. By the time the Bank of Canada raised its policy rate in early March this year, the rate of annual CPI inflation had hit 5.7 per cent – nearly three times the bank’s 2-per-cent target. Two months later, it was running at 6.8 per cent, pushed higher by a sharp rise in commodity prices after Russia’s invasion of Ukraine.
A big part of the problem was forecasting. Getting a read on inflation requires understanding where the economy is going, and very little happened the way economists expected over the past two years.
“Nobody dreamed that the recovery was going to be as soon or as sharp as what we experienced. And nobody knew for certain that it was going to be durable, even as we saw it unfolding,” Mr. Murray said.
Bank of Canada economists thought consumer demand would fall sharply at the start of the pandemic and take a long time to recover. Instead, consumer spending rebounded through the second half of 2020 and 2021, fuelled by federal government support and the early arrival of vaccines.
Labour markets were more resilient than predicted. Supply chains, on the other hand, turned out to be surprisingly fragile – buckling as consumer spending shifted from vacations and in-person services to manufactured goods such as electronics and furniture. This showed up in higher shipping costs, delays and shortages.
“Our work relies on having a clear view of the future so we can generate our outlook for the economy and inflation,” Bank of Canada senior deputy governor Carolyn Rogers said in a speech in Toronto earlier this month. “A clear view of the future has been hard to come by for anyone these last two years, and there were some things we got wrong.”
Many observers are sympathetic to this argument. After all, most private-sector forecasters were equally bad at predicting inflation.
But forecasting errors alone don’t explain why the Bank of Canada delayed tightening monetary policy in the face of rising inflation. Central banks aren’t computers that react automatically to incoming data; monetary policy involves weighing risks and making judgments.
Derek Holt, head of capital markets economics at Bank of Nova Scotia, said the central bank bungled its risk management job by not taking out “insurance” against the possibility it was wrong about inflation. It didn’t need to commence a full-blown rate-increase cycle last summer or fall, he said, but it could have made one or two small moves to hedge its bets.
“They can still have that view [that high inflation will be temporary]. But if you’ve moved away from emergency conditions, you probably want to chip away at the degree of stimulus you’re providing in a way that makes the risks a bit more balanced,” he said.
Much of the inflation last year came from oil and supply-constrained goods, such as automobiles – things over which monetary policy has little control, and which central bankers typically “look through.” But in holding off, the bank found itself behind the curve when domestic sources of inflation tied to services began picking up through the back half of the year.
One complicating factor was the Bank of Canada’s use of “forward guidance.” In the summer of 2020, it promised to keep its policy rate near zero until the economy was operating at full potential and the job market had fully recovered.
This locked the bank into a track. Even as inflationary pressures built through the summer and the fall, it doubled down on its promise not to raise rates until economic “slack” had been absorbed. To measure slack, officials said they were watching for signs of an “inclusive” labour market recovery.
“Basically what they wanted to test is how low you could get [with unemployment],” said Stéfane Marion, chief economist at National Bank of Canada.
“You can’t just blame [shutdowns in] China for goods inflation, or Ukraine and Russia for food and energy prices. There’s more than that. Service inflation is picking up because labour markets are really tight,” he said.
This was echoed by Craig Wright, chief economist at Royal Bank of Canada. He said much of the economics profession was lulled into a false sense of security about how low unemployment could get before the strong labour market added to inflation.
“We hadn’t seen any inflationary pressures for so long, we were pushing our collective luck, if you will, by going deeper and deeper into labour market tightening,” he said.
There may also have been institutional reasons for holding off rate hikes. Through last summer and fall, central bankers were waiting on the federal government to renew the Bank of Canada’s inflation-targeting mandate. This process, which happens every five years and sets the bank’s high-level monetary policy goals, was delayed by the September federal election. It was not finalized and announced until mid-December.
“Until that happened, I’m sure it was a bit awkward at the Bank of Canada to be making a big change in policy when they didn’t know if their mandate was going to be renewed,” Prof. Melino said.
This dynamic seems to have occurred at the U.S. Federal Reserve. Randal Quarles, who retired from the Fed’s board of governors in December, said on a recent podcast that the Fed’s ability to respond to rising inflation was hampered by uncertainty surrounding Mr. Powell’s reappointment as chair. This was not finalized until late November.
The Bank of Canada did not make anyone available for an interview for this article, citing the blackout period ahead of the bank’s rate decision next week.
For some observers, the roots of the bank’s mistake run deeper. Philip Cross, a senior fellow at the Macdonald Laurier Institute and a former chief economic analyst at Statistics Canada, said that the bank misstepped by not paying attention to the money supply. The amount of money in circulation expanded significantly during the first year of the pandemic, partly as a result of the bank’s QE program.
“People who put a lot of emphasis on the money supply, they weren’t fooled, they were waiting for this [period of inflation],” Mr. Cross said.
Pierre Siklos, a professor of economics at Wilfrid Laurier University, said the misread on inflation may have emerged from the disconnect between central bank models and the real world when it comes to inflation expectations.
“These models can generate inflation if the conditions are right. They just didn’t see a rise in inflation with this severity, because their models are predicated on the idea that the inflation expectations are anchored, and that the bank is always credible,” he said.
“If the bank says inflation is going to go back down to the inflation target range within a year or two, the model buys that without any questions. The public don’t always buy those arguments.”
The Bank of Canada has now swung into action. It raised rates at back-to-back meetings in March and April, and is widely expected to announce another oversized half-point rate hike next Wednesday. That would bring the policy rate up to 1.5 per cent, just a quarter-point below where it was before the pandemic.
Bank officials have said they intend to get the benchmark rate to between 2 per cent and 3 per cent relatively quickly, and may move it higher depending on how the economy responds to greater borrowing costs.
This amounts to a 180-degree turn in a matter of months. Gone are the doves counselling patience and talking about the importance of labour-market inclusion; in are the hawks, promising to wrestle inflation back down, even if it means causing significant economic pain. It’s the same individuals, but with a very different mission.
Mr. Murray said he’s not convinced earlier rate hikes, say in December or January, would have made a huge difference in terms of cooling Canada’s overheating economy. But they might have sent an important message.
“Expectations are so important, even if in some sense materially adjusting the interest rates earlier wouldn’t have made an enormous difference, given the lags in monetary policy effectiveness, it’s still the signal you’re sending of concern,” he said.
Keeping inflation expectations anchored is the Bank of Canada’s most pressing task. Bank economists still believe consumer price growth should ease as oil prices level off and supply chains improve. But if Canadians stop believing in the bank’s 2-per-cent inflation target, it will be a lot harder to get a handle on price growth.
Moving ahead, the task for central bankers will be taking lessons learned over the past year and preparing for the next turn of the business cycle. Mr. Holt offered two suggestions: “Don’t promise what you can’t deliver; so don’t promise people that their rates are never going to go up for years and years. And go back to a nuts-and-bolts risk-management framework that looks at all possible perspectives in a much more balanced way.”
Canada’s top central bankers appear to understand their brief. Ms. Rogers used her first speech as senior deputy governor, earlier this month, to highlight the importance of trust and the need to shore up credibility.
“Trust is often tested in a crisis, and there is no question that central banks have been tested by the unpredictability brought on by the pandemic,” she said.
“We know we have a ways to go before Canadians can fully judge the success of our actions.”
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