Nelson Joannette, right, is helped by Bob Stoyanovski, the owner of Upper Cut Meats, while shopping for steaks in the St. Lawrence Markets on Nov. 17, 2021.Fred Lum/the Globe and Mail
Bank of Canada officials spent much of 2021 assuring people that this period of high inflation would be relatively short-lived. The shape of monetary policy next year could depend to a significant degree on whether Canadians continue to believe this narrative.
Since the mid-1990s, households and businesses have generally trusted the central bank to keep inflation low and stable, and have anchored their own predictions for consumer price growth around the bank’s 2-per-cent inflation target.
The continuing period of rapid price growth, however, has reignited worries among economists that public expectations could become unmoored. The ultimate fear is wage-price spirals, which drove inflation in the 1970s and 80s. These occur if businesses and employees lose faith in monetary policy and start setting and demanding progressively higher prices and wages in a mutually reinforcing cycle.
Bank of Canada policy makers maintain that medium- and long-term inflation expectations remain close to the central bank’s target, and that the pace of inflation will decline over the course of next year as supply chain bottlenecks clear and consumption patterns normalize. But this narrative has become less certain in recent months, and talk about high inflation as a “transitory” phenomenon has disappeared from central-bank communications.
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Deputy governor Toni Gravelle warned in a December speech that the longer supply chain problems continue to push up consumer prices, the more likely it is that today’s inflation will become entrenched in expectations and wage bargaining. That could lead to a “second round of price increases,” he said.
The psychology of inflation matters a great deal to central banks. Economists have long believed that where people think prices are headed has a significant impact on where they end up. Indeed, monetary policy is often as much about managing expectations as it is about changing interest rates, said Jean Boivin, head of the BlackRock Investment Institute and a former Bank of Canada deputy governor.
“If you can keep inflation expectations anchored, [high inflation] is something that resolves itself,” Dr. Boivin said in an interview.
“If people start to expect more [inflation], then we will have a worse outcome for everyone,” he said, saying that central banks have historically needed to raise interest rates aggressively to bring runaway inflation expectations back in line, even if this means pushing the economy into a recession.
The most famous example of this was the “Volcker Shock” of the early 1980s, when U.S. Federal reserve chair Paul Volcker wrestled inflation expectations back to the ground with painfully high rates, causing a global slump.
Current signals about inflation expectations are mixed. The Bank of Canada’s most recent quarterly business survey, conducted in August and September, found that 45 per cent of respondents believed the rate of inflation would be above 3 per cent for the next two years – the highest proportion since the survey began in 2001.
A separate survey of consumers found that the median projection for the rate of inflation a year from now was 3.7 per cent, the highest since the survey began in 2014.
On the other hand, the majority of businesses surveyed said they believed that the forces pushing up consumer prices were temporary. For consumers, inflation expectations two and five years out remained around 3 per cent. New survey results will be published in January.
“On balance, the evidence from surveys, forecasters and bond markets points to a notable pickup in the one-year outlook on inflation, but no significant shift in longer-term expectations – yet,” Bank of Montreal economists Douglas Porter, Benjamin Reitzes and Shelly Kaushik wrote in a note to clients in October, surveying the available data.
“However, the steady upswing in a variety of longer-term U.S. expectations metrics, the increased public focus on inflation in recent months, and the sustained strength in energy prices all suggest that Canadian expectations may also shift in a more meaningful way,” they wrote.
This situation requires deft communications from the central bank. Inflation has become a major topic of everyday conversation, media coverage and political debate, with Conservative politicians regularly haranguing the federal government and the central bank about monetary policy. That provides a volatile backdrop to attempts by the bank to change its narrative about inflation and lay the groundwork for interest-rate hikes, which it expects to begin in the middle quarters of next year.
“If you’re the central banker, you want to do everything to convince people that ‘we will deliver ultimately on our mandate, you should really expect two per cent.’ The more you start to communicate that you’re worried about that, you’re kind of giving credence to those inflation expectation worries,” Dr. Boivin said.
The task is complicated by the fact that economists don’t have a particularly good grasp of how inflation expectations are actually formed, he said. Central bankers know what it looks like when inflation expectations are well anchored. But their economic models aren’t well equipped to determine when expectations are about to come unmoored.
“Central banks are in a tricky situation, because they don’t have a good handle on what to look for to start to be worried about inflation expectations. You need to make sure you avoid it, but you don’t know how much flexibility you have,” he said.
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Luba Petersen, an associate professor of economics at Simon Fraser University, studies how expectations are formed using laboratory experiments. She said that people tend to rely heavily on recent inflation statistics and their own personal experiences when formulating beliefs about inflation.
“They like to overweight, if anything, popular goods that they tend to spend on: so gasoline, meat, rent,” Prof. Petersen said. She added that people also tend to focus on real estate prices, despite the fact that the Consumer Price Index, the main measure of inflation, treats owned-accommodation as an asset rather than a consumer good and puts little weight on real estate prices.
With these factors influencing inflation perceptions, central banks need to work doubly hard to keep expectations anchored in periods of rapid price growth and red-hot housing markets.
It doesn’t help that central bank forecasts have been shifting during the pandemic. Early on, policy makers were mainly concerned about deflation. As the economy rebounded through the second half of 2020 and 2021, central bankers said high inflation would be “transitory.” In November, Bank of Canada Governor Tiff Macklem used the awkward phrase “transitory but not short-lived,” then dropped the word altogether from the bank’s rate decision announcement in December.
Prof. Peterson said the changing narrative is understandable because of complicated and shifting global supply chain dynamics. She said the bank’s best course of action is to be clear with Canadians about why its views have shifted.
“I think if they are upfront about it – ‘look, that’s what lead to unexpectedly more persistent inflation’ – I think that Canadians will take that as an acceptable answer and be kind of forgiving of the bank for making these kind of forecasting errors,” she said.
Malik Shukayev, an associate professor of economics at the University of Alberta and a former Bank of Canada researcher, echoed this view.
“I think Bank of Canada credibility is not likely to be hurt by a sincere mistake,” Prof. Shukayev said.
“Credibility suffers when the policy makers promise something and they do not really do it,” he said. “The latest communication was that the Bank of Canada expects to start raising rates in the middle of 2022; if that doesn’t happen, then I guess people will start asking questions.”
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Mark Rendell