At the end of a long news conference on Wednesday after the Bank of Canada’s biggest single interest-rate increase in more than two decades, the central bank’s Governor, Tiff Macklem, faced a final question that was both frank and straight to the point.
“Is there a recognition that the Bank of Canada waited too long to start raising rates?”
Mr. Macklem spent the next couple of minutes skirting and recasting the question. But the answer is not a hard one.
Yes, the Bank of Canada absolutely waited too long to start raising rates.
And yes, the half-percentage-point increase announced on Wednesday – double the bank’s usual quarter-point rate changes – is tacit recognition that the bank has fallen behind the curve. It may have to raise rates faster, and higher, to catch up.
The central bank’s own numbers say so.
The bank’s Monetary Policy Report – its quarterly economic review and outlook, issued at the same time as Wednesday’s rate hike – shows a lot more than the three-decade-high inflation that is the bank’s major preoccupation. It also shows an economy already running beyond its capacity, as relentlessly strong demand has surpassed supply, a critical factor that will continue feeding inflation long after near-term issues driving spikes in fuel and food prices subside.
This is now, unquestionably, a domestic inflation problem – one of Canadian demand exceeding the economy’s capacity to supply it. And it has the potential to get a fair bit worse before it gets better.
The bank forecast that the Canadian economy will grow by 4.2 per cent this year and another 3.2 per cent next year – a pace that will almost certainly outstrip capacity growth (which it pegs at about 2 per cent a year). That will continue to heap inflationary pressure onto the pile.
So now, the bank finds itself making unusually large rate increases – something, indeed, that no Canadian central banker has had to do in a generation. It’s hard to paint it as anything other than an acknowledgement that the situation has got away from the bank.
In fairness, we’ve just gone through a crisis that was utterly unique and highly unpredictable. The Bank of Canada is far from the only advanced-economy central bank that spent the past two years giving the economy as much help as it could to avoid severe damage from the pandemic, only to have growth and inflation race ahead of expectations in a recovery that has been both stronger and more complicated than anyone predicted. In a lot of ways, the Bank of Canada has been ahead of its peers in beginning to unwind their powerful pandemic stimulus measures, including Wednesday’s half-percentage-point leap. Other major central banks will certainly follow suit.
Even as Mr. Macklem and his colleagues began talking about raising rates late last year, they had reasons to think they had more time. The Omicron variant of COVID-19 looked like it would deliver a serious, if temporary, setback for the economy. As it turned out, it really didn’t, leaving the economy not only running hotter than most experts had expected, but signalling that underlying demand is even stronger than the bank had thought.
At the same time, the war in Ukraine has both turned up the inflation pressures and sharply raised profits for Canada’s resource sector, delivering more unanticipated strength to the economy.
Still, there was enough writing on the wall – writing that Mr. Macklem and the rest of the bank’s governing council could clearly see – that the time had come as much as four months ago to start raising rates. In mid-December, Mr. Macklem was suggesting that most of the slack in the economy had already been absorbed, and employment had fully recovered its pandemic losses. By late January, the bank openly declared the economy at full capacity.
But the bank made no move on interest rates in December. In January, it again held steady, opting only to withdraw its so-called forward guidance – its explicit pledge to hold rates at their bottom “until economic slack is absorbed.” It set the stage for a first rate hike in early March, nearly three months after the bank had publicly started talking about the conditions looking about right to start raising rates.
Mr. Macklem made a crisis-fighting promise in 2020 to keep his foot on the policy gas until the economy and the labour market were fully recovered, and he repeatedly pledged to be clear and deliberate when starting to reverse the policy course. Given the severity of the crisis, there were compelling reasons to make such promises, and Mr. Macklem never wavered from them. The approach contributed to the success of the recovery, and it made a complicated policy shift well-understood, well-communicated and predictable.
But with those pledges, he also painted himself into a corner. Policy became slow to respond to the rapid changes in the landscape over the past few months. The price to pay for erring on the side of patience is a steeper rate path. Mr. Macklem and his colleagues will have to confront, in the months ahead, whether waiting was worth it.
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