Home Economy Why the Bank of Canada should raise interest rates again this week

Why the Bank of Canada should raise interest rates again this week

by SuperiorInvest

Theo Argitis and Andrew Spence: History tells us policymakers should resist the temptation to loosen monetary and fiscal restraints

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Canadian work a inflation this month’s data suggests the much-coveted smooth landing stays well within reach.

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The risk is that some may see this as a reason to start loosening monetary and fiscal restraints. History tells us that politicians should resist this temptation.

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We see clear signs that price pressures are easing, with inflation expected to fall below four percent within a few months from 6.3 percent in December and 8.1 percent in June. On the work side and monster job gain 104,000 last month suggests that this year’s expected decline could be very modest.

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It is a real possibility that the country will experience mild recession strong enough to curb inflation, but not so strong as to cause a large loss of employment—the real Goldilocks result. But the best chance of achieving this scenario is to stay the course on tight demand policies, which should include another quarter-point increase Bank of Canada on January 25.

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The central bank is revising its forecasts this week, but in October it forecast inflation would average 4.1 percent in 2023, down from 6.8 percent last year.

There have been only a small number of one-year disinflationary episodes of this magnitude since World War II. This happened in 1983 and 1992, but only after severe monetary tightening triggered a deep recession.

It also happened in 1976, the year Trudeau père introduced wage and price controls to slow inflation, which had risen to 12 percent. But these efforts were in vain.

A combination of premature monetary easing and a lack of fiscal discipline—in part because policymakers let their guard down—allowed inflation to rebound and return to double-digit levels. These policy mistakes would eventually force the Bank of Canada to push short-term rates above 20 per cent in the early 1980s, causing perhaps the deepest downturn since the Great Depression.

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We believe a more useful guide for today happened 70 years ago, as the start of the Korean War in 1950 shot inflation up to 13 percent. Douglas Abbott, Minister of Finance at the time under Prime Minister Louis St. Laurent, aggressively reined in demand even as the economy began to slow. He imposed surcharges on both companies and households, while the Bank of Canada used its influence over commercial banks to slow lending.

Large defense spending created excess demand, but it was tighter fiscal policy that rebalanced supply and demand to ease inflationary pressures. The recession was shallow because inflation expectations did not track actual higher inflation. It worked. Inflation would average about one percent over the next decade.

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These four disinflationary episodes provide two key lessons.

First, inflation expectations are important and determine how tight policy needs to be and how deep a recession will be. The painful and costly disinflation of the 1980s and 1990s was a product of stubborn and high inflation expectations. In contrast, the absence of high inflation expectations during the Korean War meant that the recession was short-lived and fiscal policy did the heavy lifting.

Second, fiscal policy is important to monetary policy. If demand needs to be reined in and fiscal policy won’t help, then the Bank of Canada has some hard work to do. Today, the federal government is more concerned with redistribution than economic management, which means interest rates have to go higher than they would otherwise.

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However, today’s inflation expectations, especially long-term market-based expectations, remain well anchored, suggesting that a deep disinflationary recession is not necessary and short-term expectations are easing.

After failing to identify the crisis in time, the Bank of Canada has put together a masterclass in managing inflation expectations with a determined tourism cycle that is starting to bite. The federal and provincial governments have been less helpful, and while that doesn’t add to the problem, the bank needs to tighten more than it would in the absence of tighter fiscal policy.

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The Canadian central bank cannot yet consider easing its monetary position until it is confident that it has accomplished its task. The coming downturn will be particularly painful for indebted households suffering from rising debt payments. Finance Minister Chrystia Freeland and her provincial counterparts will feel political pressure to deal with some of the economic problems many Canadians will face this year.

But it would be a shame to risk progress that has been made for short-term political expediency. We’re almost there. As the British proverb says, there is no fatigue on the day of victory.

Theo Argitis is the Managing Director of Compass Rose Group. Andrew Spence is an independent consultant specializing in economics, investment strategy and risk.

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