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Parliamentary Budget Officer Yves Giroux's office decided to crunch the numbers to estimate what would happen if the Bank of Canada overstepped with its rate increases.Dave Chan/The Globe and Mail

After six interest rate increases totalling 3.5 percentage points – and with the promise of still more to come – there’s a growing urgency to the questions the Bank of Canada faces about its aggressive pursuit to snuff out inflation.

How high is the central bank willing to go? How far is too far? And how much economic collateral damage might the bank inflict if its policy tips into overzealousness?

With the question becoming an increasing preoccupation of Ottawa policy makers and a broad swath of the Canadian public, the Office of the Parliamentary Budget Officer decided to crunch the numbers to estimate what would happen if the Bank of Canada overstepped with its rate increases.

Predictably, it’s not good. Arguably, it might be tolerable.

But surprisingly, it might not make much difference. In what was both the report’s most unexpected and its most valuable finding, the PBO concluded that overdoing it might not wipe out inflation any faster.

In what Parliamentary Budget Officer Yves Giroux stressed was a purely hypothetical exercise and absolutely not a prediction, his office analyzed the impact of the central bank taking its key rate to 5 per cent – another 1.25 percentage points above the current 3.75 per cent, and well beyond the 4-per-cent to 4.5-per-cent area where most economists, including the PBO, have forecast as the likely top of this rate cycle. (It assumed that other central banks, and specifically the U.S. Federal Reserve, would similarly push their policy rates higher than expected.)

The researchers estimated that in this “overtightening” scenario, the economy would slow significantly and would suffer a mild recession through most of next year. The labour market would shed an estimated 177,000 jobs, and the unemployment rate would rise to about 6.2 per cent by early 2024, a full percentage point higher than it is today. The federal deficit (typically the PBO’s primary concern) would swell to about $43-billion in the 2023-24 budget year, compared with the PBO’s base-case forecast of $26-billion – even if Ottawa doesn’t lift a spending finger to help cushion the recession’s blow.

While those outcomes would, obviously, be unwelcome, they are hardly disastrous. The recession that the PBO analysis predicts – a GDP contraction of 0.3 per cent for 2023 as a whole – is a pretty tame one by historical standards. A peak unemployment rate of 6.2 per cent would actually be lower than Canada has had for most of the past 50 years, and would represent a remarkably mild increase for a recession. The envisioned deficit increase – if the government remains disciplined in the face of such an economic downturn – is well within the range of manageable.

But here’s the kicker of the PBO’s analysis: This higher Bank of Canada interest rate would not alter the course of inflation reduction over the next two or three years. It figures that in its scenario where the global economy is similarly slowed by rate-policy overshoots by the Fed and other central banks, the resulting declines in global commodity prices will weaken the Canadian dollar and, thus, offset any disinflationary effects from weakened domestic demand.

If the PBO’s analysis is accurate, overshooting on rates would inflict a fair bit of damage for nothing. It wouldn’t get the Bank of Canada any closer, any sooner, to its overarching goal of returning inflation to the bank’s 2-per-cent target.

It is, of course, hard to know just how clear the PBO’s crystal ball on this is. Few things about the COVID-19 recession and recovery, and the Canadian and global economy’s response to policy actions, have been easy to predict. Pinpointing the exact appropriate interest rate to bring inflation back to target, and anticipating the range of economic consequences resulting from not one but several central banks exceeding that rate, is a pretty bold analytical challenge.

Still, it’s compelling that the PBO is making its attempt at a time when the Bank of Canada is asking exactly the same questions itself, with apparent growing urgency, as it tries to determine how much further to push the interest rate envelope.

Over the past few weeks, Bank of Canada Governor Tiff Macklem has begun to talk regularly about “trying to balance the risks of over and undertightening monetary policy.” The bank’s latest economic forecasts, issued in late October, envision essentially zero growth through the middle of next year, and Mr. Macklem has acknowledged that it’s essentially a coin toss whether the economy tips into contraction over the next three quarters. Last week, he warned of the likelihood of rising unemployment, but said that “we don’t expect the kind of large increases in unemployment that we’ve seen in past recessions. We’re not expecting high unemployment by historical standards.”

Mr. Macklem has been adamant that rates do still need to move higher from here. We have at least one more hike coming in the early-December rate decision, and quite possibly another in the pipeline for January.

But the bank’s recent communications certainly suggest that it is busy running a lot of the same numbers and scenarios that the PBO tackled, and that such analyses on the risks of overtightening are going to be critical to both the decision-making process and the bank’s public message in the next few months. Perhaps Mr. Macklem might want to take Mr. Giroux for a coffee; it looks like they have a lot to talk about.

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