Bank of Canada stuck wondering why interest rate hikes have not been enough to tame inflation

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In the ways that matter most, the July inflation figures didn’t tell the Bank of Canada anything it didn’t already know.

That’s the problem.

Tuesday’s news of a jump in the consumer price index year-over-year inflation rate, to 3.3 per cent in July from 2.8 per cent in June, may have been an unwelcome surprise for many Canadians, but it was entirely consistent with what the central bank has been warning about for months.

Yes, inflation had previously been declining, but it had been helped along by some favourable year-over-year gasoline price comparisons that have now faded out of the numbers. Core measures of inflation are still well above the bank’s 2-per-cent inflation target, implying that the economy is still saddled with stubborn underlying inflation pressures. The services side of the economy is still proving resistant to rising interest rates.

These are all things that the Bank of Canada had already been saying. The data merely restated the bank’s case that it has not yet won its battle against inflation.

But what the bank doesn’t know – what has become the critical question now, both for the bank and for the economic ramifications of this battle – is why.

Why haven’t 4.75 percentage points of interest rate hikes over the past 17 months been sufficient to slow down the economy enough to tame inflation? Why have usually predictable effects on demand and employment been so muted this time around?

Is it because interest rates still aren’t high enough? Or is it because we haven’t waited long enough for them to do their work?

Without an answer, the bank now finds itself trying to make its best guess. The risks, either way, are substantial.

The bank’s summary of its governing council’s deliberations leading up to last month’s rate increase revealed that these “two scenarios” now form the core of the debate among its leadership over where to take rate policy next.

“If policy is not restrictive enough to bring inflation to target on a reasonable timetable, there is a risk that rates will have to be increased by even more later,” the summary document said. “If policy is simply taking longer to work because the lagged effects of nominal tightening are only recently starting to have an impact on overall consumption, over-tightening risks making economic conditions more painful than necessary.”

The governing council’s ensuing rate decision spoke to which risk they feared more. They decided it was safer to raise rates again.

“The consensus among members was that the cost of delaying action was larger than the benefit of waiting,” the summary said.

But hedging bets on the question is not the same as having an answer.

If any facet of the economy holds the key to unlocking this mystery, it’s likely the labour market. Employment has very conspicuously resisted the Bank of Canada’s attempts to put a disinflationary chill on the overheated economy.

While job growth has moderated, it remains much stronger than in any typical economic downturn. The unemployment rate has ticked up to 5.5 per cent from 5 per cent just a few months ago, but that’s still low by historical standards.

A huge overhang of job vacancies – which exceeded one million when the Bank of Canada began raising interest rates in the spring of 2022 – has provided an unprecedented buffer for employment against the impact of rising rates. Those vacancies have declined by more than 250,000 over the past year, yet they’re still well above historical norms.

The Bank of Canada initially looked at this as a good thing. The labour market could lose a great deal of demand without necessarily shedding jobs – it could just whittle down the stockpile of vacancies. We could, then, absorb a substantial economic slowdown and a surge in interest rates without a painful spike in unemployment, avoiding the kind of damage that tips slowdowns into recessions. This was the main ingredient in the recipe for a soft landing.

But now, that glut of available jobs is a big part of the problem. It’s underpinning consumer demand even as borrowing costs continue to rise. It’s sustaining high wage growth, a critical fuel for inflation.

This is as good an explanation as any – and better than most – for the missing traction of tighter monetary policy. The typical slowdowns in employment, wages and consumer demand have been held at bay by an unprecedented gap between labour supply and demand that hasn’t yet closed.

If this is, indeed, the culprit, then the employment data could be the best place for the central bank to look for its answers. If the job market continues to moderate and vacancies continue to retreat toward historically normal levels, that would argue that current interest rate levels are doing the job as intended. It may only take the clearing of the remaining job-vacancy overhang to open the gates for existing rate policy to have its overdue effect on inflation.

Unfortunately, the Bank of Canada goes into its next rate decision on Sept. 6 without the benefit of August employment data, which will come out two days later. The bank may well decide once again that it’s safer to raise rates one more time, in the absence of data that provide some of the answers it awaits.