by Mario Seccareccia
July 19, 2022
From the Monetary Policy Institute: Has the Bank of Canada already abandoned its new mandate a mere six months after its adoption?
From the Monetary Policy Institute: Has the Bank of Canada already abandoned its new mandate a mere six months after its adoption?
Credit: Michelle Spollen / Unsplash
On July 13, the Bank of Canada raised its policy interest rate by an aggressive 100 basis points, making it the biggest hike in almost a quarter century. Given its 2 per cent inflation target and an inflation rate at 7.7 percent in May, it was hardly surprising to see another rate jump.
At the end of January, the Bank officially removed its so-called “exceptional” forward guidance — which kept its policy interest rate pegged for over two years at 0.25 percent since the beginning of the pandemic — and since, we have seen a subsequent revision of its forward guidance. Now, the target overnight/policy rate would have to reach its estimated non-inflationary “neutral” interest rate range of between 2–3 percent mid-point. This would ensure that Canada’s inflation returns to its 2 percent target by 2024.
Hence, given the official forewarnings, the upward path taken for its policy interest rate, which started in early March with an initial mild increase of 25 basis points, was certainly predictable. However, the speedy acceleration of the policy rate increases, which have been bringing its policy rate prematurely closer towards its “neutral” level in 2022, is a surprise. Its policy rate first went up by 50 basis points each time in April and again in early June, and now we observe what Governor Macklem refers to as a “front-end loading”: a 100 basis-point jump in July!
This essentially multiplies its overnight rate tenfold — to 2.5 percent within approximately five months. We are told by the Governor that the recent more aggressive measure was needed to prevent inflationary expectations from becoming entrenched in the price/wage setting process since the overall inflation has now become generalised with the Bank’s “core” measures of Canada’s inflation rate having recently jumped from 3.9 percent to 5.4 percent.
One can easily become entangled within the technical universe of the Bank of Canada. Indeed, many policy analysts in Canada have been swayed by the Bank’s repeated assertion that, as a modern inflation-fighting central bank, it can well plan and clinically engineer a programmed disinflation within the next two years. However, given the blunt instrument that it disposes, it may well face a credibility problem. The Bank recognizes that there are some extremely serious risks with the adoption of this hawkish interest-rate experiment, which, sadly, we have seen before with the “mother” of these interest-rate increases being the famous “Volcker shock” in the United States, over four decades ago.
Viewed superficially from its decision on July 13, it would seem that the Bank is currently betting that it can initiate a significant “shock” effect so as to prevent the increasing inflationary expectations from becoming “entrenched” and that it can manage a smooth disinflation or “soft landing” without significantly damaging the country’s fragile growth as the Canadian economy struggles to come out of the COVID-19 crisis.
Unfortunately for the Bank’s communication strategy, not everyone believes this — not even the financial community! A revealing example is the evolution of the Canadian dollar immediately following the announcement of the 100-basis points hike, which, instead of the expected currency appreciation (as the textbooks would predict with a large interest-rate increase), the loonie actually dropped to a 20-month low vis-à-vis the US dollar immediately following the rate increase!
Contrary to those who explain this decline in the Canadian dollar on the expected rise in the US Federal Funds Rate by 75 basis points later in July, I believe the principal reason is the fear that this hawkish Bank of Canada behaviour could generate yet another recession in Canada, especially after just having suffered the terrible damages from Covid-19 over the last two years.
Visibly, there are many who believe that the Bank will not manage this programmed disinflation in Canada particularly well. In fact, as recognized in a recent study by David Macdonald at the Canadian Centre for Policy Alternatives, there is no historical precedence over the last half century that our central bank can manage significant rate hikes of the magnitude that we have witnessed cumulatively over the last few months without causing a serious recession. While the Bank actually does predict slower growth for 2023 and 2024 because of the slow return towards increasing austerity, researchers at the Bank do not predict the negative growth that Macdonald’s historical evidence actually suggests.
In light of this, a few obvious questions all Canadians should be asking are: why is the Bank not considering such empirical evidence? And why is it willing to risk what predictably can be a “hard landing” with an expressed desire to return to higher unemployment levels after just a very short interval over the last few months of unusually low unemployment and high vacancy rates?
After all, this growing labour market tightness may well be merely a special feature of an economy recovering from the ongoing pandemic rather than a normal feature of an economy that is overheating. Some recent work would suggest that we are still far from the type of full-employment rates of unemployment that, for instance, had prevailed in the early postwar period in Canada.
Moreover, has Governor Macklem forgotten or deliberately overlooked the new mandate of the Bank of Canada that was adopted by the Trudeau government just a mere six months ago in December 2021? Is he ignoring the evidence that its discretionary interest-rate policy might create a significant recession accompanied by predictably much higher unemployment? While the priority for the Bank of Canada remains its 2 percent inflation target, it cannot officially disregard the potential impact that its interest rate policy can have on the unemployment rate — which after all does have an official mention in its new five-year monetary policy mandate. The risks of a hard landing have been completely ignored with its aggressive “front-end loading” of the Bank’s interest-rate increases.
Also, in its official statement, the Bank does correctly recognize that the principal drivers of the inflation rate in Canada are “global factors such as the war in Ukraine and ongoing supply disruptions”. Yet, in the same breath, it concludes that “domestic price pressures from excess demand are becoming more prominent.” But what precisely is the evidence that the demand-side factors are taking on a “more prominent” role in pushing upward the inflation rate?
As stated above, the historically-high job vacancy rate may merely be symptomatic of specific labour-market problems connected with our recovery from the pandemic and not an indicator of generalized excess-demand problems in the product markets. Much of the empirical evidence produced in the United States, which includes work done by some US Fed economists, would suggest that demand-side factors are not at all predominant in explaining product price increases and that the inflation rate has actually become somewhat unresponsive to demand-side indicators, such as the unemployment rate, thereby revealing a relatively flat Phillips Curve.
If the inflation rate is not very responsive to rising unemployment, and if most of the inflation is related to supply-side problems that the Bank cannot control, such as international oil price increases, then why inflict the pain of higher unemployment on the Canadian economy? Given the high sacrifice ratio of getting the inflation rate down even marginally, why should wage earners bear the burden of the Bank’s anti-inflation policy?
The only logical conclusion that one can derive from this hawkish policy is that the Bank is deliberately taking side against labour by preventing wages from rising and catching up with the inflation rate. To achieve that, it must increase the unemployment rate significantly so as to weaken the bargaining power especially of organised labour. Much of the evidence from the United States points to significant rises in profit markups of business enterprises throughout 2021 and early 2022. Labour has been very slow to redress that widening gap between prices and wages by demanding higher wage increases that have significantly lagged behind price increases.
Even in Canada, we have seen wage increases lagging significantly behind inflation. For instance, as late as in May, consumer prices grew by 7.7 percent while average hourly wages grew by 3.9 percent. Seeing that wage increases are beginning to accelerate with a jump to 5.2 percent in June, the Bank has decided to make full use of its interest-rate lever to prevent this wage catch-up. The potential effect of the interest rate hike is to slow down significantly the economy and generate higher unemployment. When looked at from the angle of labour, such a policy must raise a fundamental moral question of controlling inflation for whom?
In sum, what if the Bank succeeds in controlling wage growth but the inflation rate continues to be sustained by international factors over which the Bank actually has no control? Why would it de facto be taking side by imposing the burden of the inflation on workers? One must remind the Bank that during that whole era of “inflation first” monetary policy since the 1980s, workers saw their share of national income decline significantly even though, over the longer term during that era especially before the Global Financial Crisis, wages were actually growing more or less commensurate with consumer prices. As is well known, the reason why the share of labour declined over those decades was because real wages were flat while the economy’s productivity grew, thereby expanding the shares of profit and interest income earners at the expense of labour’s share.
On July 13, 2022, in its fight against inflation, the Bank is not only offering the prospect of a familiar decline in the share of labour, which working people in Canada had suffered already to a very great extent since the 1980s, but it is also offering a predictable decline in real wages over the coming years. When looked at through the looking glass of its incidence on ordinary working Canadians, there is a fundamental moral problem to which the Bank seems to be noticeably insensitive. In the current context, it is wrong to raise interest rates so quickly whose only predictable outcome is higher unemployment that will slow down wage growth so as to prevent a wage-price spiral that would otherwise become an inflationary “add-on” domestically to the imported international supply-side inflation over which admittedly the Bank of Canada has no control.
As raised elsewhere, surely one ought to consider a more equitable solution to this wage-price spiral than this biased “class war” outcome in which an important agency of the federal government has chosen to take side against labour.
Reference:
Seccareccia, Mario (2022), “Can the Pursuit of Fiscal and Monetary Policies Achieve a Meaningful Full-Employment Objective without Inflation? Learning from the Canadian Historical Experience, including the Recent COVID-19 Crisis”, Paper presented at the XXII Seminar of Fiscal and Financial Economics, Public and Private Credit: National and Global Experiences in the Current Crisis, National Autonomous University of Mexico, Mexico City (March 30).
This piece originally appeared in the Monetary Policy Institute.
On July 13, the Bank of Canada raised its policy interest rate by an aggressive 100 basis points, making it the biggest hike in almost a quarter century. Given its 2 per cent inflation target and an inflation rate at 7.7 percent in May, it was hardly surprising to see another rate jump.
At the end of January, the Bank officially removed its so-called “exceptional” forward guidance — which kept its policy interest rate pegged for over two years at 0.25 percent since the beginning of the pandemic — and since, we have seen a subsequent revision of its forward guidance. Now, the target overnight/policy rate would have to reach its estimated non-inflationary “neutral” interest rate range of between 2–3 percent mid-point. This would ensure that Canada’s inflation returns to its 2 percent target by 2024.
Hence, given the official forewarnings, the upward path taken for its policy interest rate, which started in early March with an initial mild increase of 25 basis points, was certainly predictable. However, the speedy acceleration of the policy rate increases, which have been bringing its policy rate prematurely closer towards its “neutral” level in 2022, is a surprise. Its policy rate first went up by 50 basis points each time in April and again in early June, and now we observe what Governor Macklem refers to as a “front-end loading”: a 100 basis-point jump in July!
This essentially multiplies its overnight rate tenfold — to 2.5 percent within approximately five months. We are told by the Governor that the recent more aggressive measure was needed to prevent inflationary expectations from becoming entrenched in the price/wage setting process since the overall inflation has now become generalised with the Bank’s “core” measures of Canada’s inflation rate having recently jumped from 3.9 percent to 5.4 percent.
One can easily become entangled within the technical universe of the Bank of Canada. Indeed, many policy analysts in Canada have been swayed by the Bank’s repeated assertion that, as a modern inflation-fighting central bank, it can well plan and clinically engineer a programmed disinflation within the next two years. However, given the blunt instrument that it disposes, it may well face a credibility problem. The Bank recognizes that there are some extremely serious risks with the adoption of this hawkish interest-rate experiment, which, sadly, we have seen before with the “mother” of these interest-rate increases being the famous “Volcker shock” in the United States, over four decades ago.
Viewed superficially from its decision on July 13, it would seem that the Bank is currently betting that it can initiate a significant “shock” effect so as to prevent the increasing inflationary expectations from becoming “entrenched” and that it can manage a smooth disinflation or “soft landing” without significantly damaging the country’s fragile growth as the Canadian economy struggles to come out of the COVID-19 crisis.
Unfortunately for the Bank’s communication strategy, not everyone believes this — not even the financial community! A revealing example is the evolution of the Canadian dollar immediately following the announcement of the 100-basis points hike, which, instead of the expected currency appreciation (as the textbooks would predict with a large interest-rate increase), the loonie actually dropped to a 20-month low vis-à-vis the US dollar immediately following the rate increase!
Contrary to those who explain this decline in the Canadian dollar on the expected rise in the US Federal Funds Rate by 75 basis points later in July, I believe the principal reason is the fear that this hawkish Bank of Canada behaviour could generate yet another recession in Canada, especially after just having suffered the terrible damages from Covid-19 over the last two years.
Visibly, there are many who believe that the Bank will not manage this programmed disinflation in Canada particularly well. In fact, as recognized in a recent study by David Macdonald at the Canadian Centre for Policy Alternatives, there is no historical precedence over the last half century that our central bank can manage significant rate hikes of the magnitude that we have witnessed cumulatively over the last few months without causing a serious recession. While the Bank actually does predict slower growth for 2023 and 2024 because of the slow return towards increasing austerity, researchers at the Bank do not predict the negative growth that Macdonald’s historical evidence actually suggests.
In light of this, a few obvious questions all Canadians should be asking are: why is the Bank not considering such empirical evidence? And why is it willing to risk what predictably can be a “hard landing” with an expressed desire to return to higher unemployment levels after just a very short interval over the last few months of unusually low unemployment and high vacancy rates?
After all, this growing labour market tightness may well be merely a special feature of an economy recovering from the ongoing pandemic rather than a normal feature of an economy that is overheating. Some recent work would suggest that we are still far from the type of full-employment rates of unemployment that, for instance, had prevailed in the early postwar period in Canada.
Moreover, has Governor Macklem forgotten or deliberately overlooked the new mandate of the Bank of Canada that was adopted by the Trudeau government just a mere six months ago in December 2021? Is he ignoring the evidence that its discretionary interest-rate policy might create a significant recession accompanied by predictably much higher unemployment? While the priority for the Bank of Canada remains its 2 percent inflation target, it cannot officially disregard the potential impact that its interest rate policy can have on the unemployment rate — which after all does have an official mention in its new five-year monetary policy mandate. The risks of a hard landing have been completely ignored with its aggressive “front-end loading” of the Bank’s interest-rate increases.
Also, in its official statement, the Bank does correctly recognize that the principal drivers of the inflation rate in Canada are “global factors such as the war in Ukraine and ongoing supply disruptions”. Yet, in the same breath, it concludes that “domestic price pressures from excess demand are becoming more prominent.” But what precisely is the evidence that the demand-side factors are taking on a “more prominent” role in pushing upward the inflation rate?
As stated above, the historically-high job vacancy rate may merely be symptomatic of specific labour-market problems connected with our recovery from the pandemic and not an indicator of generalized excess-demand problems in the product markets. Much of the empirical evidence produced in the United States, which includes work done by some US Fed economists, would suggest that demand-side factors are not at all predominant in explaining product price increases and that the inflation rate has actually become somewhat unresponsive to demand-side indicators, such as the unemployment rate, thereby revealing a relatively flat Phillips Curve.
If the inflation rate is not very responsive to rising unemployment, and if most of the inflation is related to supply-side problems that the Bank cannot control, such as international oil price increases, then why inflict the pain of higher unemployment on the Canadian economy? Given the high sacrifice ratio of getting the inflation rate down even marginally, why should wage earners bear the burden of the Bank’s anti-inflation policy?
The only logical conclusion that one can derive from this hawkish policy is that the Bank is deliberately taking side against labour by preventing wages from rising and catching up with the inflation rate. To achieve that, it must increase the unemployment rate significantly so as to weaken the bargaining power especially of organised labour. Much of the evidence from the United States points to significant rises in profit markups of business enterprises throughout 2021 and early 2022. Labour has been very slow to redress that widening gap between prices and wages by demanding higher wage increases that have significantly lagged behind price increases.
Even in Canada, we have seen wage increases lagging significantly behind inflation. For instance, as late as in May, consumer prices grew by 7.7 percent while average hourly wages grew by 3.9 percent. Seeing that wage increases are beginning to accelerate with a jump to 5.2 percent in June, the Bank has decided to make full use of its interest-rate lever to prevent this wage catch-up. The potential effect of the interest rate hike is to slow down significantly the economy and generate higher unemployment. When looked at from the angle of labour, such a policy must raise a fundamental moral question of controlling inflation for whom?
In sum, what if the Bank succeeds in controlling wage growth but the inflation rate continues to be sustained by international factors over which the Bank actually has no control? Why would it de facto be taking side by imposing the burden of the inflation on workers? One must remind the Bank that during that whole era of “inflation first” monetary policy since the 1980s, workers saw their share of national income decline significantly even though, over the longer term during that era especially before the Global Financial Crisis, wages were actually growing more or less commensurate with consumer prices. As is well known, the reason why the share of labour declined over those decades was because real wages were flat while the economy’s productivity grew, thereby expanding the shares of profit and interest income earners at the expense of labour’s share.
On July 13, 2022, in its fight against inflation, the Bank is not only offering the prospect of a familiar decline in the share of labour, which working people in Canada had suffered already to a very great extent since the 1980s, but it is also offering a predictable decline in real wages over the coming years. When looked at through the looking glass of its incidence on ordinary working Canadians, there is a fundamental moral problem to which the Bank seems to be noticeably insensitive. In the current context, it is wrong to raise interest rates so quickly whose only predictable outcome is higher unemployment that will slow down wage growth so as to prevent a wage-price spiral that would otherwise become an inflationary “add-on” domestically to the imported international supply-side inflation over which admittedly the Bank of Canada has no control.
As raised elsewhere, surely one ought to consider a more equitable solution to this wage-price spiral than this biased “class war” outcome in which an important agency of the federal government has chosen to take side against labour.
Reference:
Seccareccia, Mario (2022), “Can the Pursuit of Fiscal and Monetary Policies Achieve a Meaningful Full-Employment Objective without Inflation? Learning from the Canadian Historical Experience, including the Recent COVID-19 Crisis”, Paper presented at the XXII Seminar of Fiscal and Financial Economics, Public and Private Credit: National and Global Experiences in the Current Crisis, National Autonomous University of Mexico, Mexico City (March 30).
This piece originally appeared in the Monetary Policy Institute.
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