Bank of Canada is likely to overdo it in inflation fight

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Credibility is hard to earn but easy to lose. After losing quite a bit of it over the past year, the Bank of Canada is working hard to get it back.

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Governor Tiff Macklem’s decision on July 12 to raise interest rates once again, and leave the door open for even more hikes, is in part an effort to restore public confidence in the central bank’s commitment to its two per cent inflation target.

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Quick recap. Last year’s inflation surge caught the central bank by surprise, prompting it to jack up interest rates dramatically to slow the economy and ease price pressures. Interest rates have risen by 4.75 percentage points, with the overnight policy rate now at five per cent — the highest since 2001.

Inflation peaked at 8.1 per cent in June last year and has since come down sharply, with the latest reading at 3.4 per cent, in part as energy prices fell from highs.

But bringing inflation down any further will be a lot harder from here, and Macklem is already feeling the heat as the higher rates take a toll on borrowers.

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At a press conference on July 12, the Bank of Canada chief said he’s “acutely aware” the rate hikes are making life more difficult for many households. He sought to reassure Canadians the Bank is trying to find the right balance between controlling inflation and not overtightening.

But overdoing it is probably the more likely outcome.

One of the most significant bits of news yesterday was the Bank of Canada’s acknowledgement that inflation will take longer than expected to return to two per cent. Its latest forecast is not until the middle of 2025.

That means almost four years of above-target inflation — which is a worryingly long time.

Central bankers know that the longer inflation persists above target, the more likely expectations will harden at these higher levels. And because expected inflation is a major determinant of actual inflation, you create potentially self-fulfilling dynamics of persistently higher inflation.

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Businesses increase prices and workers seek pay raises on what they anticipate prices will look like in future. Should inflation expectations harden at current levels, then inflation won’t come down.

This worry was front and centre in the July 12 policy decision.

“Governing Council remains concerned that progress towards the two per cent target could stall, jeopardizing the return to price stability,” officials said in their statement.

Separately, in his opening statement to reporters, Macklem warned inflation could “even rise again if there are upside surprises.”

This doesn’t sound like a central bank that is ready to declare victory.

Central bankers see inflation control as an exercise in expectations management. After failing to identify the inflation crisis early on, the Bank of Canada has put together a determined hiking cycle to bring those inflation expectations back down.

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It has made a lot of progress, but Canadians are still in need of convincing.

This is apparent in worker wage demands that are driving up pay by between four per cent and five per cent annually, according to Bank of Canada estimates. It’s also apparent in how frequently businesses are increasing prices.

For Macklem, the more credible he’s perceived on inflation, the more price and wage expectations will remain in check — and the greater the chances of a soft landing.

The Bank of Canada not only needs to calibrate demand in the economy, but also needs to signal that it’s tough and serious on inflation. This may mean having to keep rates higher than what simple models of economic slack would suggest.

Indebted Canadians should continue to brace themselves.

Theo Argitis is managing director at Compass Rose Group

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