Bank of Canada’s Beaudry pushes back against recession forecasts

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The Bank of Canada is pushing back against the idea it will need to cause a recession to get prices under control, while assuring financial markets it will take “whatever actions are necessary” to bring inflation back to target.

In a speech on Tuesday, deputy governor Paul Beaudry challenged the idea that returning inflation to the bank’s 2-per-cent target will necessarily entail a sustained economic contraction.

The trajectory of inflation depends to a significant degree on what individuals and businesses believe about future inflation, he argued. If people’s expectations for future inflation remain well-anchored, it “greatly reduces the need to engineer a period of significant economic slack to get back to target on a sustainable basis,” he said.

The lecture to students at the University of Waterloo followed Statistics Canada’s release of August inflation data, which showed the annual rate of Consumer Price Index growth fell to 7 per cent last month, down from 7.6 per cent in July and 8.1 per cent in June.

Mr. Beaudry said inflation was “headed in the right direction,” but remained “too high.”

His comments land in the middle of a debate about whether Canada is heading toward a recession. The Bank of Canada has raised interest rates five times since March in an effort to cool down Canada’s overheating economy and slow the pace of consumer price growth. That included a 0.75-percentage-point rate hike earlier this month, bringing the bank’s benchmark rate to 3.25 per cent.

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The aggressive pace of rate hikes is already hitting the economy hard, leading to a sharp decline in housing market activity and a pullback in consumer spending. A growing number of private-sector forecasters, including economists at Royal Bank of Canada RY-T and Desjardins DCU-T, now expect the Canadian economy to fall into recession next year.

The Bank of Canada projects a sharp slowdown in economic growth in the second half of the year and into 2023. But central bank officials have maintained that what policy makers call a “soft-landing” is possible – in which inflation recedes without a spike in unemployment or a sustained fall in economic activity.

Mr. Beaudry’s argument focused on the role inflation expectations play in this debate.

Economists have long argued that what people believe about future inflation has an impact on where inflation ends up. If businesses and individuals expect inflation to remain permanently high, they will push up prices and demand higher wages in a self-reinforcing cycle. This kind of wage-price spiral, which occurred in the 1970s and early 1980s, can be very difficult to break once it has taken root.

“To avoid this and bring inflation sustainably back to target, some have suggested that policy makers may need to engineer a substantial slowdown – or even a recession,” Mr. Beaudry said.

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He pushed back against this idea, arguing it doesn’t account for competing theories about how people form beliefs about future inflation.

“The best strategy for responding to high inflation – and, most importantly, for avoiding de-anchoring [of inflation expectations] – depends partly on how people form their inflation expectations,” he said.

There’s a debate among economists about whether people form beliefs about future inflation based on past experiences, or by looking forward with an understanding of how monetary policy will impact future inflation.

If the first theory is true, central banks can’t do much to influence expectations and need to choke the economy with painfully high interest rates to bring elevated inflation down and re-anchor expectations. If the second theory is true, central banks have more scope to guide inflation expectations and inflation itself through communication.

“The truth, as you can imagine, lies somewhere between these theories,” Mr. Beaudry said, suggesting the central bank believes it has some ability to influence inflation expectations.

“This is where direct, effective monetary policy communication has an important role to play,” Mr. Beaudry said. “The more effective the bank can be in its guiding role, the greater the chance of a soft landing – and the lower the risk of a hard landing.”

Royce Mendes, head of macro strategy at Desjardins, noted Mr. Beaudry’s speech did not offer any definite conclusions on the question of whether a recession is necessary or not.

“They’re still holding out hope that their reassurances that inflation is coming down will ward off a much-feared inflationary mindset,” Mr. Mendes wrote in a note to clients.

“But actions speak louder than words. The pace of increases clearly shows that if the central bank has to make a choice between avoiding a recession and controlling inflation, they will choose the latter every time,” he wrote.