James Thorne is chief market strategist at Wellington-Altus Private Wealth Inc. in Toronto.
The Bank of Canada (BoC) is teetering on the edge of a potentially disastrous policy mistake. The inflation shock is now over. Inflation rates have declined dramatically during the past year, and there’s no solid evidence to suggest Canada’s economy is overheating. The central bank is now at a point at which it must adopt a monetary policy that’s independent of the U.S. Federal Reserve Board.
Canada’s economy is not as diversified as that of our southern neighbours, and having a real overnight policy rate in line or tighter than the Fed’s increases the probability of Canada’s economy experiencing a severe recession. Although the U.S. is well on its way to a soft landing, the same cannot be said for Canada. That’s why the BoC needs to change course forthwith and cut interest rates instead of raising them further.
The delicate balance between controlling inflation and maintaining economic stability has been debated in economics for decades. In the 1970s, U.S. Congressman Wright Patman once compared hiking interest rates to fight inflation with putting gasoline on a fire to stop the flames. It serves as a cautionary tale, reminding us of the delicate nature of policy decisions on the economy and the need for a thoughtful and balanced approach. While it’s essential to acknowledge that inflation is influenced by many factors beyond interest rates, the overly aggressive monetary policy the BoC has implemented these past 18 months prompts us to reflect on the lessons from history that are being ignored.
The fears about the risk of the economy overheating and accelerating inflation are misplaced. Excluding the effects of the BoC’s interest rate hikes, which have contributed to 30 per cent of the most recent measure of the consumer price index, Canada’s inflation currently stands at 2 per cent, aligning with the mid-point of the central bank’s legislative target range. Inflation is under control, eliminating one of the primary concerns of an overheating economy. Furthermore, analyzing the historical patterns of inflation, it’s evident that additional exogenous shocks caused second spikes in the 1950s and 1970s – the outbreak of the Korean War and the Iran Revolution, respectively – rather than inherent economic factors.
Moreover, when evaluating StatsCan data objectively, it becomes evident that Canada’s economy is not experiencing robust growth. On the contrary, consumer spending is subdued, with retail sales ex-autos at negative 1.5 per cent, below the 20-year average of 4.7 per cent. In addition, the three-month annualized gross domestic product (GDP) growth rate is 1.5 per cent, below the 20-year average of 1.97 per cent. The producer price index (PPI) is negative 5.5 per cent, the worst in the G7. This downward trend in input prices suggests that businesses are not facing cost pressures. Unemployment is increasing and wage growth is declining. Labour productivity growth fell by 0.6 per cent in the first quarter. The combination of factors does not align with the typical symptoms of an overheating economy, with excess demand.
Before the onset of the COVID-19 pandemic, deflationary forces were already present in the global economy. Factors such as demographics, extreme levels of debt, and technological innovation were already exerting downward pressure on prices. These forces have only been strengthened recently, making it even more crucial for central banks to tread carefully. Looking at the current situation in Japan, it becomes clear that tightening monetary policy aggressively doesn’t necessarily solve the problem of inflation caused by supply shocks. The Bank of Japan (BoJ) has refrained from implementing interest rate hikes, yet inflation in Japan continues to drop.
Furthermore, it’s also worth noting that the BoJ’s dovish approach is not an isolated occurrence. Deflation is occurring in China, and the Bank of China has begun to cut interest rates. Europe has witnessed a rapid tightening of financial conditions, falling inflation rates, negative PPI, and some countries experiencing recessionary GDP growth; it’s becoming increasingly evident that the European Central Bank is considering a more dovish approach. Thus, it’s not unreasonable to question whether the BoC should also follow suit – especially when household debt as a percentage of disposable income in Canada is at 187 per cent, higher than any other country in the G7.
The BoC must chart a path toward sustainable economic growth and price stability by recognizing the limitations of traditional monetary policy tools, acknowledging the strengthening of deflationary forces post-COVID-19, and adopting a comprehensive, flexible and data-driven approach. By doing so, the BoC can better navigate the complexities of the current economic landscape and work toward sustainable economic growth and price stability.
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