Bank of Canada is bleeding the economy, just like 19th-century doctors bled patients

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Jim Stanford is economist and director of the Centre for Future Work. David Naylor is a physician, clinical epidemiologist and former president of the University of Toronto.

In the 19th century, before scientists understood the causes of most acute and chronic diseases, doctors routinely treated illness by bleeding their patients. Using an array of gruesome techniques (from deliberate wounds to the application of leeches), clinicians thought they could restore a patient’s health by eliminating impure blood.

Perversely, doctors attributed negative reactions to bloodletting – such as bounding pulse, weakness and fainting – to the disease, not their misguided treatments. The resulting iatrogenic death toll will never be known.

This medical analogy seems painfully applicable to the current course of treatment for Canadian inflation. With 10 interest-rate hikes in 18 months, the Bank of Canada is trying to drain what it thinks caused the disease – in its view, excess spending by ordinary households – from the bloodstream of Canada’s economy.

The patient is showing obvious distress: gross domestic product shrank in two of the past three quarters, unemployment is rising and major banks have set aside billions in loan-loss provisions for expected defaults. But now, the most conclusive symptom of mistreatment is evidence that higher interest rates, themselves, are causing more inflation, not less.

The cost of shelter is the biggest single category in the Consumer Price Index, with a 28-per-cent weighting. Interest charges on mortgages are a large component of those housing costs. They have skyrocketed because of the bank’s actions: up a record 30.6 per cent over the past year, adding almost one full percentage point to inflation.

Indeed, excluding mortgage debt charges, Statistics Canada reports current inflation would be 2.4 per cent, well within the bank’s target band (2 per cent plus or minus one percentage point).

Of course, monetary hawks would argue that it is only because of the rate hikes that inflation, minus mortgages costs, has fallen to such a level. But higher housing expenses not only disproportionately drive the CPI; they also offset consumer savings from price reductions supposedly attributable to central-bank policy.

So, it is also undeniable that higher interest rates, for now, are contributing to higher inflation. And the further inflation falls, this perverse impact is proportionately larger – giving all the more reason to be cautious about further rate increases.

Like those 19th-century medics, however, Bank of Canada clinicians seek to explain away the side effects of their treatment. For example, Governor Tiff Macklem argued recently that mortgage debt charges are best excluded from estimates of underlying, or core, inflation precisely because they have increased so rapidly. While that line of thinking has merit, the path Mr. Macklem pursues from there does not.

Mr. Macklem prefers a synthetic CPI-trim measure of inflation, from which the central bank excludes items with the biggest price changes – up or down. By this measure, which excludes mortgage debt – and many products whose prices are falling – inflation is still a danger, possibly necessitating more rate hikes. This gambit will be cold comfort to mortgage holders, who have no such ability to simply exclude debt charges from their actual cost of living.

Moreover, the adverse effects of high interest rates on housing costs reach far beyond this direct link to mortgage charges. Rents are also soaring, in part because Canadians who cannot afford to buy must turn to the rental market.

Most ominously, new housing construction in Canada is imploding. Residential investment has fallen 21 per cent since the bank began tightening. Given the existing housing shortage, and Canada’s surging population (up 1.2 million in the past year), contracting housing supply clearly implies even faster shelter inflation in the future.

Instead of fretting about this, Mr. Macklem highlights weak construction as an encouraging sign that higher interest rates are reducing spending and rebalancing demand and supply. He also acknowledges most of the recent decline in the inflation rate, falling quickly from 8.1 per cent in June, 2022, reflects falling energy prices and repaired global supply chains – things not sensitive to his interest-rate adjustments.

What explains this obtuseness? Studies of clinical decision-making highlight the importance of the chagrin factor: doctors fear that failure to act will lead to deep regret if there is a bad outcome. It is hard not to sense the chagrin factor at work in the bank’s deliberations – chagrin at not having responded faster to late-pandemic inflation, followed by fear that failure to act decisively now will allow inflation to become a chronic condition.

But in addition to technical skill, knowing when not to intervene is often what defines the best clinicians. Indeed, the tincture of time is sometimes the best medicine. One can only hope that a more precise consideration of risk-benefit ratios and restraint will prevail as the Bank of Canada navigates the months ahead.