BoC leans its weight against inflation fears without changing its view about temporary nature of price spikes

The Bank of Canada has been staring inflation in the face for a while now. On Wednesday, it blinked.

It may not have been a huge, theatrical, mouth-agape kind of blink. But it was perceptible and significant all the same.

Wednesday’s monetary policy decision didn’t include an immediate rate increase to combat surging inflation (no one expected that it would), but it did go considerably further in addressing inflation worries than the central bank has been willing to go before. While the bank isn’t giving up on its argument that this year’s rising prices are a temporary phenomenon, the rate announcement and accompanying quarterly Monetary Policy Report quite clearly demonstrate the institution’s desire to start leaning its weight against inflation fears – whether or not it entirely agrees with them.

The big development was its message that rate hikes will likely begin about three months earlier than it had previously signalled – which involved some clever engineering.

To get there, the bank didn’t focus so much on the still-rising inflation rate, which hit 4.4 per cent last month, and which it expects to approach 5 per cent by the end of the year – far beyond its 1-per-cent to 3-per-cent target range.

Rather, the bank honed in on how the apparent chief cause of that inflation – severe supply bottlenecks – will alter the pace of the economic recovery.

It concluded that these supply constraints mean that the output gap – the amount of spare supply capacity in the economy – is smaller than the bank previously thought. Not only that, but with those supply problems being “stronger and more persistent” than the bank had anticipated, demand growth looks likely to eat up the remaining gap earlier than previously expected.

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The closing of this gap will provide the signal the central bank is looking for to start raising interest rates. The bank now expects that signal to flash green “sometime in the middle quarters of 2022,” rather than its previous projection of “the second half of 2022.” The change opens the door for a first rate hike as early as next spring, should conditions warrant.

It’s notable that these conditions don’t necessarily require evidence that the inflation problem is becoming broader or more entrenched. The bank still thinks that the global supply-chain disruptions, as persistent as they are, won’t last. Nevertheless, as Bank of Canada Governor Tiff Macklem explained Wednesday, the supply flows won’t unclog fast enough to keep up with still-rising demand.

“Yes, the supply capacity is coming back [next year], but demand will have caught up. So, we’ll actually be in a little bit of excess demand after that,” Mr. Macklem said in a news conference after the rate announcement.

In essence, the bank is now saying that transitory supply disruptions do matter to the bigger policy picture after all, should they overstay their welcome.” If they constrain supplies long enough for the output gap to close, then they justify rate action.

It all adds up, without the bank having to meaningfully change its view about the temporary nature of the current inflation spike. Still, it’s hard to escape the sense that the bank worked all of this out chiefly to step up its inflation game and show a nervous public that it’s on top of this.

Indeed, that was a message Mr. Macklem delivered in Wednesday’s news conference. When asked a couple of times about what the bank could do to quell Canadians’ fears surrounding the current surge in prices, he pointed directly to the bank’s decision to move forward its expected timing of rate hikes.

“The message to Canadians is, we have been adjusting, and we will continue to adjust to bring inflation back to the 2-per-cent target.”

That certainly left the impression that there was more to the new rate-timing outlook than simply output-gap arithmetic.

But the rate timing was only one element of the Bank of Canada’s tougher message on inflation. The bank’s statement accompanying its rate decision – a short but highly important document that is always closely scrutinized for changes from previous statements – included a significant new sentence detailing the key factors the bank will be monitoring for evidence that inflation is becoming a more entrenched problem.

“The bank is closely watching inflation expectations and labour costs to ensure that the temporary forces pushing up prices do not become embedded in ongoing inflation,” it said.

This wasn’t exactly news to anyone who had been following Mr. Macklem’s recent comments on inflation. Still, its inclusion in the policy statement underlines the seriousness with which the bank is addressing the risk – and its desire to make sure the public knows about it.

“I want to assure Canadians that we can and we will keep inflation under control. We understand what our job is,” Mr. Macklem said.

A central bank’s communications strategy is a key part of winning any inflation battle. On Wednesday, the Bank of Canada finally gave out a battle cry and engaged the enemy.

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