Governor of the Bank of Canada Tiff Macklem holds a news conference in Ottawa in May.PATRICK DOYLE/The Canadian Press
Craig Alexander has served as chief economist at Deloitte Canada, the Conference Board of Canada and Toronto-Dominion Bank.
The Bank of Canada will announce on Wednesday whether it is raising interest rates again. Any hawkish members of the Governing Council who favour hiking will argue that inflation is still above the bank’s 1-to-3-per-cent target band, and that it is not known when inflation will return to the midpoint 2-per-cent operational goal. They will also point to the surprising resilience of the economy after previous increases in interest rates.
However, the case for leaving interest rates unchanged is stronger and more compelling.
Inflation has been retreating, and it is becoming less broad-based. To illustrate, inflation dropped to 3.4 per cent in May, but it was 2.4 per cent when food prices were excluded from the calculation. It dropped from 3.4 per cent to 2.5 per cent when the impact of mortgage interest costs was removed.
Yes, you read that right. When the impact of higher mortgage costs arising from the central bank’s prior interest rate hikes is excluded, inflation is within the bank’s target band.
If one tracks how price pressures have evolved by category of goods and services over the past three years, it becomes apparent that the Bank of Canada was right when it said in 2021 that the inflation shock was primarily due to a disruption of global supply chains that was temporarily pushing up prices. Supply chains took much longer than anyone expected to work through the damage done by the pandemic, but inflation has fallen as they have normalized, and as the price effects have been resolved.
Looking at the economic and inflation trends, it appears that the Bank of Canada’s previous rate hikes have had little impact on reducing inflation. Real estate prices have fallen, but not by much. Consumer spending is weaker, but expenditures on interest-rate-sensitive goods and services have still increased. The labour market has reduced the number of unfilled jobs, but employment growth remains healthy and unemployment remains low.
The problem is that the country could start feeling the lagged impact of the central bank’s previous rate hikes just as inflation is receding toward the bank’s target range. It takes 18 to 24 months for the full impact of higher interest rates to be realized. And interest rates are now above the rate of inflation, which means real interest rates will be a bigger drag on the economy going forward.
Meanwhile, the financial pressure on households has been intensifying. The Financial Consumer Agency of Canada reported that the share of Canadians who have no problems keeping up with their financial commitments fell from 57 per cent at the end of 2021 to 39 per cent at the end of 2022. The share of households that spend more than they earn climbed to 55 per cent for mortgage holders and 59 per cent for renters. As more mortgages renew at the prevailing higher interest rates, the debt service burden will increase.
The economy has recently been supported by record-high population growth. Higher immigration propelled a 2.7-per-cent increase in Canada’s population in 2022. This helped to support housing demand and boosted consumer spending. But population growth is expected to slow to around 1.4 per cent in 2023 and 2024.
The implication is that, even if interest rates are held steady, economic growth is likely to lose momentum in the coming months, and price pressures should continue to abate.
A key concern flagged by the Bank of Canada is the tightness of labour markets, which could generate wage growth that would prevent inflation from falling back toward the midpoint target. But there is no evidence that wage growth has been the driver of inflation.
Wage growth had trailed the pace of inflation until just recently, and inflation expectations of businesses and consumers, which influence future wage settlements, are well anchored at close to the bank’s inflation target. This suggests the recent wage growth is really about making up for lost purchasing power. If so, wage growth will slow as inflation moderates.
The latest Labour Force Survey reported that average hourly wage growth fell from 5.1 per cent year-over-year in May, to 4.2 per cent in June.
The bottom line is that the Bank of Canada was correct that the inflation shock was transitory – the shock just wasn’t short-lived, and that undermined the bank’s credibility. The bank then embarked on aggressive interest-rate hikes to ensure inflation expectations did not rise too much, and to rebalance monetary policy as the pandemic crisis passed.
The bank has taken monetary policy from highly stimulative to the economy to moderately restrictive. But the inflation shock is abating, and the lagged impact of the prior tightening of monetary policy is still working its way through the economy. It is far from evident that higher interest rates are needed. In fact, raising interest rates further could do unnecessary harm to the economy and household finances.