Inflation – Is the Bank of Canada fixing it or making it worse

By: Ken White

Inflation affects everything, making it harder to feed our families, pay rent, or even afford a home.

The Bank of Canada is trying to cool inflation by slowing down the economy. It does this by hiking interest rates, but this increases the cost of everything, causing pain for households and small businesses.

The Bank of Canada’s sledgehammer is increasing prices, especially for groceries and housing. Food prices have risen almost 10 percent, and mortgage costs are up 30 percent.

The Bank acknowledges that getting inflation down to its 2 percent target is taking much longer than expected. It won’t get there until 2025. This means four more years of pain and suffering.

Is this necessary? Can the Canadian economy survive these draconian measures?

In truth, it was never intended for the Bank of Canada to fight inflation in isolation. It must work with government agencies, specifically Finance Canada, that design the federal Budget and other regulatory agencies that regulate prices, incomes, and immigration.

Also, the tools the Bank has to fight inflation are limited. It sets the interest rate it charges commercial banks for overnight loans. This affects the rates commercial banks charge their best customers (currently 7.5 percent), while most businesses and households pay more.

The rationale is that higher interest rates will slow the economy, so households and businesses will spend less. This is happening differently than it was intended. Families are drawing down on their savings, and most mortgage holders are locked into terms ranging from two to five years.

The federal government continues spending on social programs and investments to green the economy. These expenditures negate the Bank’s efforts to slow down inflation. Also, high levels of immigration are pushing up prices, especially for housing. Immigrants are urgently needed to fill the nation’s labour shortages and skills gaps.

So what can be done to make the war on Inflation less painful?

The ship of state is being paddled in two directions. The Bank of Canada is rowing one way, and the other federal agencies are rowing in the opposite direction.

Under the current minority government environment, it is unlikely that the federal government will significantly reduce spending as much as the Bank of Canada would like them to.

What can be done if our current central banking and government policies cannot effectively fight inflation without burdening households and businesses?

In the following paragraphs, the discussion will expand on the high costs of the Bank of Canada “going alone” and summarize the results of Canada’s experiment with price and income guidelines controls in the mid-1970s to the early 1980s.

The Pain

Statistics Canada recently reported that in the first quarter of 2023, almost 70% of businesses expect to be affected by increased interest rates over the next 12 months.

Close to half (45.7%) of businesses expect to increase the selling price of goods or services offered due to the higher rates, while over 3 in 10 expect to reduce investment.

Sixty percent of businesses in accommodation and food services expect to increase prices of goods and services, followed closely by manufacturing (58.2%) and retail trade (57.7%).

Forty-one percent of businesses in agriculture, forestry, fishing, and hunting expect to reduce investment, the highest among all sectors, followed by those in transportation and warehousing (37.2%), mining, quarrying, and oil and gas extraction (37.1%).

Going Alone

Fighting inflation being left solely to the Bank of Canada has serious downsides. These downsides include:

• Higher interest rates have minimal impact on rising prices from supply bottlenecks from the pandemic or global events such as the Russian-Ukrainian war.

• The recent Port of Vancouver strike, while over now, has seriously interrupted the flow of critical supplies, which will cause prices to rise.

• Higher interest rates dampen housing construction through increased mortgage and builder credit costs. This is causing housing costs to increase, primarily rental.

• Many mortgage holders have two-year terms. Renewals for these mortgage holders in 2024 and 2025 could place a high financial risk on households if the Bank of Canada does not lower interest rates by then.

• Higher interest rates are restricting corporate capital spending. Spending on innovation allows more room for companies to make productivity-enhancing investments.

• Improving productivity would significantly lower inflation by reducing business costs and allowing corporations to substitute scarce labour for more mechanization. The current high interest carrying charges makes this investment difficult.

• Our governments provide capital spending subsidies in select “green” industries. More restrictive spending and lower interest rates would provide a more conducive environment for investment in innovation technologies.

The Bank of Canada is operating in a vacuum. Its policies need to be fixed as intended.

Price and Income Controls?

Canada was in a difficult situation in the mid to late 1970s, where inflation and economic growth co-occurred. Mortgage interest rates exceeded 20%, and wage increases were in the same range.

The Government of Canada, in October 1975, announced an anti-inflation program (AIP) which provided controls of prices and incomes over three years.

Inflation, especially wage inflation, slowed considerably “following the introduction of the AIP, but the second- and third-year implicit price-inflation targets were not met, and inflation grew again after 1978.

Interest rates rose sharply in the latter half of 1979 and 1980. A severe recession occurred from mid-1981 through 1982, and very high unemployment, price and wage inflation dropped sharply. Price inflation fell below 5 percent by 1984 and stayed there for several years.

The AIP did not meet its targets for the 1975–78 period and failed to shift inflation to a stable, reasonably low track after the controls were lifted. The AIP program did, however, succeed in slowing down rising wages.

Back to the Future

With the Bank of Canada hiking interest rates over the past year and a half (with a short pause in between), many Canadian households and businesses live in a world of hurt. The debate is still ongoing on whether hiking interest rates eventually slows inflation.

These high-interest rates, given time, will drag the economy down. Even if a recession is avoided, households and businesses will suffer greatly. The issues are “What are the costs, and can we afford them”?

Coordination and Buy in Needed

What can be done? Continuing the present trajectory of high and rising interest rates will eventually beat down inflation but at enormous social and economic costs.

Prices and income controls have shown not to work; higher prices and incomes could backfire and bounce back even higher after controls are lifted.

Better coordination with Finance Canada, the federal Budget and immigration policies is not likely in a minority government, especially when household income distribution and social needs are substantial. Immigration policies will not be tempered if Canada’s labour force shows serious skills gaps.

What can be done? Prices and income guidelines (not controls) may work.

Price and income policies require strong buy-in from corporate Canada and unions to work well. It will not work in a draconian manner.

Strong guidelines that all parties agree to could work if they all understand that the harmful effects of employing high-interest rates to fight inflation are far more significant than a collaborative approach where monetary, fiscal, and regulatory policies are operating in tandem.

Establishing better coordination and communications that monitors prices and incomes and works with significant suppliers and unions to minimize overbearing increases would place less pressure on the Bank of Canada to do it alone.

And give the rest of us more freedom from the pain of higher interest rates.

Ken White is a semi-retired economist living in Port Coquitlam, British Columbia. His recent work has been modelling the economic impacts of the green economy and defence-related innovation.

Also by Ken White  The Bank of Canada – Is it Broke or Broken?