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Even the Bank of Canada dropped the biggest hints yet that it’s preparing to start raising rates sooner rather than later.Blair Gable/Reuters

Last week may go down as the moment the world’s central bankers lost their staring contest with inflation.

Sure, there were signs before then, changes in tone that indicated concern was rising and policy was about to shift. But last week was a big, unambiguous blink on multiple fronts.

The Bank of England raised its benchmark rate for the first time in more than three years. The U.S. Federal Reserve accelerated its wind-down of asset purchases (commonly known as quantitative easing), which will bring the program to an end in March. The European Central Bank announced that it will wind down its own pandemic emergency asset-purchase program over the next quarter and end it in March.

The central banks of Mexico, Norway, Chile and Brazil all raised their interest rates.

Even the Bank of Canada, while leaving its key rate unchanged, dropped the biggest hints yet that it’s preparing to start raising rates sooner rather than later.

“We are not comfortable where we are,” Bank of Canada Governor Tiff Macklem said during an online speaking engagement last week. He was referencing the country’s 4.7-per-cent inflation rate, which is more than double the bank’s 2-per-cent target.

“We are now focused on our forward guidance – on assessing the diminishing degree of slack in the economy and on bringing inflation sustainably back to target,” he said.

For those less schooled in reading between the central-banker-speak lines, that suggests the bank is preparing to alter or drop its “forward guidance” – its standing pledge to “hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2-per-cent inflation target is sustainably achieved” – as a precursor to a rate increase. The wheels, it seems, have begun to turn.

It has escaped no one’s notice that many of these same policy makers were, only a handful of weeks ago, insisting that inflation was largely “transitory” – a temporary aberration reflecting unfavourable year-earlier comparisons built into the statistics, as well as growing pains in the recovery from a most unusual recession.

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This raises the question: Were central banks, including Canada’s, wrong about the nature of this inflation beast? Was last week a great big global mea culpa, launching a race to fix the damage?

Well, yes and no. And, more to the point, it doesn’t really matter.

There’s little question that the current year-over-year inflation rates are, indeed, being juiced by a rebound from unusually low prices a year earlier, especially for a few important items. Benchmark North American oil prices in November, for instance, were double what they were a year earlier. That degree of energy price growth is not going to continue. Some of this inflation will absolutely pass – it’s written in the data.

There’s also little doubt that increased economic activity as the pandemic threat faded over the course of the year caused supply bottlenecks. This created the kinds of price pressures that, typically, don’t last. These things get fixed. The pressures ease.

What central banks were absolutely wrong about is how long these supply pressures would last, and, often, how to talk about them. The bottlenecks did not quickly fade away; they widened to affect more of the economy. And while many central bankers insisted that this still fit their definition of “transitory” – a concept that has no particular timeframe for economists – the use of the word created a public impression that inflation might be elevated for a quarter or so, not the five-or-six-quarter period that now looks more likely.

There is now a growing concern that central banks have misread the recovery, and that there may be a lot more true underlying inflationary pressure than they had assumed. They may not have a very good sense of what economic capacity truly is, with segments of the economy still restricted, others experiencing dramatic shifts in activity brought on by the pandemic and labour markets severely rattled by the whole experience.

But that’s mostly water under the bridge. What matters most now are inflation expectations – how individuals and businesses perceive the pace of price increases, and how they alter their behaviour in response. That’s the kind of second-round inflation that leads to a more entrenched problem – the kind that’s a lot harder for central banks to correct. The longer inflation dominates the public conversation, the more risk that those expectations will shift.

Regardless of whether central banks were right or wrong, their response now is aimed at cooling those expectations before they start embedding themselves in higher wage demands, and then in retail prices, as businesses pass labour costs through to consumers.

Those second-round effects are what threaten to get ahead of central banks if they don’t take action – for the sake of public confidence as much as sound policy. If they can get on top of the fight before inflation expectations sink in any further, it won’t much matter what they got right and wrong before.

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