The Bank of Canada is conducting an experiment in mass psychology.
Amid surging inflation, economists expected the central bank’s interest rate hike on Wednesday to be hefty: three-quarters of a percentage point. But with its credibility on the line, the Bank of Canada surprised everyone and spiked its policy rate higher by a full percentage point, to 2.5 per cent.
Governor Tiff Macklem conceded the central bank’s “credibility is being tested” and that it had to forcefully demonstrate its will to corral inflation. Higher interest rates generally require many months to take hold and slow a hot economy. But a rare episode like Wednesday’s serves the immediate purpose of a declaration from the Bank of Canada to the many Canadians and businesses that believe inflation won’t ease any time soon. Mr. Macklem’s percentage-point hike is half economics and half psychology.
This is new terrain for many people. Rampant inflation existed in the hazy past, during the 1970s, oil embargoes and a stagnant economy. Relatively high interest rates in Canada lasted until the early 1990s. Everyone got used to low inflation and low rates in the decades that followed. Central bankers seemed in full control. Tectonic shifts like China’s rise in the world economy kept the prices of goods low. Technology got faster and cheaper. Oil prices were mostly modest.
The pandemic upended everything. When inflation percolated last year, central bankers dubbed it transitory. There was no chorus of calls for aggressive action. There were specific pressures like out-of-control housing prices, but the broader economy was in convalescence. Even last fall, economists predicted a return to low inflation by the end of this year. At the start of 2022, the focus was Omicron, not inflation.
Then the world gunned a cold engine. Pandemic restrictions vanished. No one travelled, until everyone travelled. Demand for labour went ballistic. Add in the war in Ukraine, and oil and food prices spiralled higher. Inflation is everywhere. If 7.7 per cent in May in Canada seems bad, look at the United States, which on Wednesday booked 9.1 per cent in June.
Now central banks are scrambling. The Bank of Canada on Wednesday said it miscalculated key factors such as oil prices. But oil is hard to predict, as is the onset of war. Central banks influence neither. So Mr. Macklem is left to convince Canadians he can get the job done. It starts with his push on Wednesday to re-establish credibility.
There are major risks involved with so aggressive a rate hike. Economists who hadn’t feared inflation last year these days warn of potential recession. Sectors such as housing are already feeling the higher rates, and this will intensify. History indicates that reducing high inflation while avoiding a recession can’t be done, yet the Bank of Canada believes it can pull off this double trick. That remains a big maybe.
These are, however, weird times. Yes, higher rates in the past have led to economic contraction, but there’s no past that really resembles the present: rapidly rising interest rates, but up from basically zero and still relatively low; unemployment at a record low, with record job vacancies; a continuing pandemic; war in Eastern Europe. Add it up and it’s hard to rely on historical comparisons.
There also are indications that inflation might be peaking. Oil, wheat, lumber and shipping rates are falling. For inflation to keep going at 8 per cent, oil would have to almost double.
Then there’s the complicated big picture question: Have things really changed – is the long era of low rates and low inflation over?
Some experts say yes, given shifts such as disruptions to global trade, climate heating and an aging population. Jean Boivin, an investment executive and former Bank of Canada deputy governor, recently wrote in the Financial Times that the past four decades, for the world economy and central bankers, were defined in part by “good luck.” Our collective economic luck – factors that kept inflation and rates low – may have run out.
The Bank of Canada is fixated on inflation. It’s too high, too widespread and too many people think it’s not going away. It had to act, and it did. It’s fair to say the bank is playing catchup. But it now clearly moves with force.
What’s not clear is whether it’ll work. Can the central bank both ease inflation and avert recession? The path to success, Mr. Macklem said, is narrowing. The cost of missteps is high.
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