By Max Sato
(MaceNews) – The Bank of Canada may need to keep raising its policy interest rate above what it sees as neutral, currently in the 2% to 3% range, as inflation has been rising faster than expected and could become much harder to control, Deputy Governor Paul Beaudry said Thursday.
He also said in a speech to the Gatineau Chamber of Commerce in Quebec that there was a shift in the view among the bank’s Governing Council between its policy decision on April 13 and the one made on Wednesday, each leading to a 50-basis-point rate hike, first to 1% and then to 1.5%.
In April, the bank’s policy-makers indicated that it was important to get the policy rate quickly back to neutral and once reaching the point, they would “consider whether to pause before raising rates further,” Beaudry said. The discussion at the time was if inflation pressures were more persistent, the bank “would likely need to move the policy rate somewhat above neutral to bring inflation back to the target,” he said.
In the deliberations for Wednesday’s policy decision, the Governing Council “noted that price pressures are broadening and inflation is much higher than we expected and likely to go higher still before easing,” Beaudry said.
“This raises the likelihood that we may need to raise the policy rate to the top end or above the neutral range to bring demand and supply into balance and keep inflation expectations well anchored,” he projected.
In its policy statement issued Wednesday, the bank said that “the Governing Council is prepared to act more forcefully if needed to meet its commitment to achieve the 2% inflation target.”
Mulling Bigger, Faster Rate Hikes
Asked what the bank meant by acting “more forcefully,” Beaudry told a news conference following his speech Thursday that the Governing Council was thinking “both in terms of the pace and the level and speed of getting there” and “we are scared that this inflation becomes entrenched.”
“We see this aspect of potentially needing to go higher than we thought before and we still have the idea that we want to get there as quickly as possible,” he said.
“That could involve more moves in a row or could involve bigger moves,” he said, referring to a possible 75-basis-point rate hike that some economists are forecasting for the bank’s next policy decision on July 13.
“All this will depend exactly on the data that comes in. We are not doing anything on an automatic pilot … trying to get feedback from the economy as we make decisions,” he said, repeating the bank’s official line.
Aiming for Soft-Landing
Asked whether Canada can tame inflation without plunging into recession, Beaudry replied, “We certainly think so,” while noting “it is a difficult balance” in the process of “aiming for soft-landing.”
The bank’s policymakers believe they can guide hot inflation back to their 2% target from the current level close to 7% without pushing the economy back into a slump “by properly communicating with people what we are doing,” he said.
The question is how much of the current excess demand the Bank of Canada has to remove and in the process of this adjustment, it “would be natural that the unemployment rate may increase a bit” from a fresh record low 5.2% in April, Beaudry said.
“If that is smooth, that doesn’t put us into recession,” he said. “What we don’t want to have is … a big increase in unemployment. We are hoping that we can get that in soft-landing, getting the labor market more in balance.”
Rising short-term inflation expectations are causing the Governing Council to “worry” but the longer-term price outlook among households and business is still anchored, Beaudry said. The bank is trying to keep Canadians from having a mindset of believing high consumer inflation, for example 6%, is normal, he said.
Learning From Errors
The bank will release its review on how it underestimated the nature of the current inflation in the quarterly Monetary Policy Report to be issued with its July 13 policy decision, he said.
“One of the aspects that we are learning a lot more about is the supply chains,” he explained. “Traditionally, we weren’t looking into all the details of how a bottleneck of one part of the supply chains in the world leads up to other price changes.”
“That’s how we made errors on inflation forecast as almost everyone else who was trying to predict inflation made these errors,” he said. “The aspect is to try to learn from your errors and not making the same errors as we go forward.”
External shocks from surging energy and commodities prices pushed up Canada’s inflation well above the bank’s 2% target but the bank didn’t raise rates until March 2, when it conducted its first interest rate hike since October 2018 and lifted the policy rate to 0.5% from its record low 0.25%.
In his speech, Beaudry said the bank opted against raising interest rates earlier for three reasons. First, inflationary shocks coming from abroad are often “temporary” and second, Second, for most of 2021, the economy was operating well below capacity, and thus there was no excess demand. Third, premature tightening could impede the ability of people who lost jobs during the pandemic to find work again.
“And we were clear about this in our communications, which indicated that we intended to leave interest rates at their lowest possible level until the slack in the economy from the pandemic was absorbed,” said the deputy governor.
Since then, data have shown that the rebound in the economy, especially in employment, has been much faster than the bank anticipated, thanks to large fiscal and monetary policy stimulus, effective vaccines, and the ability of Canadians to adapt and innovate, he said.
“We expect strong growth and low unemployment to continue,” Beaudry said. “And looking forward, robust business investment, improved labour productivity and strong immigration should help boost the economy’s productive capacity.”
“At close to 7% today, inflation is well above our most recent forecast, and it is likely to move even higher in the near term before beginning to ease,” he forecast.
“Entrenched inflation comes about when inflation feeds on itself,” Beaudry said, referring to the cycle of a higher cost of living prompting workers to seek higher wages, which in turn push up overall prices. “No ongoing outside force—such as supply shortages or strengthening demand—is needed to feed this type of inflation. It becomes largely self-fulfilling, with the main driver being expectations that inflation will stay high or keep rising,” he explained.
“History shows that once high inflation is entrenched, bringing it back down without severely hampering the economy is hard,” he said. “Preventing high inflation from becoming entrenched is much more desirable than trying to quash it once it has.”
Central banks respond to the prospect of such demand-driven inflation by raising interest rates to slow economic activity, which helps realign demand with supply.
“In our case, we began raising interest rates once we judged that the output gap—essentially, the gap between what the economy is capable of producing and its actual output—had closed,” Beaudry said.
Before starting its rate hike cycle, he said, the bank looked at trade-offs in policy decisions, “choosing between tolerating above-target inflation that might last longer than we think or needlessly weakening the economy and employment if it turns out we were too quick to tighten.”
“The unprecedented and highly uncertain environment of the pandemic has made such calculations much more challenging,” he added.
“The risk we were managing was that if higher inflation lasted longer than anticipated, it could eventually affect expectations and start to become entrenched,” Beaudry said. “This risk seemed appropriate to take at the time, given the slack in the economy and the view that the supply-driven sources of elevated inflation would likely prove temporary.”
But now the Canadian economy is in excess demand and inflation has proved to be more stubborn.
“The initial disruptions to international supply chains have persisted longer and broadened more than we expected, partly reflecting strong demand in the world economy,” Beaudry said. “They have also been exacerbated by subsequent developments that we did not anticipate—the war in Ukraine and the extent of the strict lockdowns affecting much of China.”
“The bottom line is that the risk is now greater that inflation expectations could de-anchor and high inflation could become entrenched,” he said.
Quantitative Tightening to Support Rate Hikes
The bank decided on April 13 to begin the process of quantitative tightening, effective April 25. It has now stopped reinvesting in government bonds and let its swollen balance sheet shrink in line with economic recovery from the pandemic-caused slump.
After peaking at C$575 billion in early 2021, the bank’s balance sheet is now close
to $465 billion, down almost 20%. Based on the maturity profile of our portfolio, the bank expects its asset holdings (mostly government debt) to fall from around C$440 billion at the end of 2021 to about C$280 billion by the end of 2023, a further decline of more than 35%.
“So, reducing our Government of Canada bond holdings should further push up borrowing costs for households and businesses, which is necessary to rebalance demand with supply in the economy,” Beaudry said.