Bank of Canada Governor Tiff Macklem said there is a “greater risk” of not doing enough to tackle inflation than doing too much and damaging economic growth, even as the bank has signalled that it is nearing the end of its aggressive rate-hike cycle.
In a year-end speech in Vancouver, Mr. Macklem reiterated that the central bank has entered a new phase of monetary policy. After raising interest rates seven consecutive times, the bank has moved from asking how big the next rate hike should be to asking whether to raise interest rates at all. That could mean a pause to rate increases as early as January.
But Mr. Macklem also suggested that the bank remains concerned about throwing in the towel too early. The annual rate of inflation was 6.9 per cent in October, still more than three times the bank’s 2-per-cent inflation target.
“If we raise rates too much, we could drive the economy into an unnecessarily painful recession and undershoot the inflation target,” he said at the event, held by the Business Council of British Columbia.
“If we don’t raise them enough, inflation will remain elevated, and households and businesses will come to expect persistently high inflation. With inflation running well above target, this is the greater risk.”
Mr. Macklem’s comments follow a 50-basis-point rate increase last Wednesday, which raised the bank’s benchmark rate to 4.25 per cent, the highest level since early 2008. The bank also suggested last week that it was preparing to step back and assess the impact of its historic tightening campaign, which has raised mortgage costs dramatically over the past nine months.
Interest rate increases work with a lag, first hitting rate-sensitive sectors like housing and car sales, then squeezing consumer spending over time as homeowners renew their mortgages at higher rates. This delay makes it hard to judge the impact of rate hikes in real time and creates the risk of overtightening monetary policy.
The bank’s next rate announcement is on Jan. 25. Mr. Macklem said the decision about whether to press pause would depend on incoming data.
In a speech last week, Bank of Canada deputy governor Sharon Kozicki said the bank was still willing to be “forceful” with rate increases, if economic data came in stronger than expected. Mr. Macklem’s focus on Monday on the upside risk to inflation suggests a January pause is not necessarily the base-case scenario.
Recent economic data have been mixed. Inflation is trending down, but also broadening out, impacting a wider range of goods and services. The Canadian economy grew much faster than the bank expected in the third quarter, but there are also signs that rate hikes are starting to bite. Household spending fell 0.3 per cent in the third quarter, the first drop since the second quarter of 2021.
Much of Mr. Macklem’s speech was devoted to what the central bank has learned over the past year as inflation surged to the highest level in four decades. In particular, Mr. Macklem said the bank underestimated the impact of supply-side shocks on inflation. These included factory shutdowns and shipping backlogs during the first two years of the pandemic, as well as Russia’s invasion of Ukraine this year, which pushed oil and other commodity prices sharply higher.
“Since we started inflation targeting in the early 1990s, we have not been hit by large negative supply shocks at the same time as our economy was overheating,” he said.
“The lesson from 2022 is that even if long-term inflation expectations are well anchored, when the economy is in excess demand, businesses raise their prices more quickly and by more when their costs increase.”
The speech also pointed to potential challenges for the central bank ahead. Many of the tectonic forces that have put downward pressure on prices in recent decades, including the expansion of global trade and the entry of Chinese and Eastern European workers into world labour markets, seem to be going in reverse. The COVID-19 pandemic and Russia’s invasion of Ukraine have shaken assumptions about the global economy.
“In the future, it seems likely that supply chains will be shorter, more diversified and more resilient. Trade will likely narrow to more trusted partners. These changes will increase resilience but at the cost of efficiency. And through this adjustment, production costs could rise, increasing price pressures,” Mr. Macklem said.
He said these changes could make it harder to control inflation. “How much harder is very difficult to say.”