The TMX Market Centre is shown in Toronto, Sept. 11. In Canada, headline inflation hit the bullseye in August, thanks in part to falling oil prices. But it is expected to fluctuate around the target in the coming months, and measures of underlying price pressures remain several notches above 2 per cent.Paige Taylor White/The Canadian Press
When the Bank of Canada and the U.S. Federal Reserve started choking their economies with oversized interest-rate hikes in 2022, the outlook appeared grave. Either inflation would continue spiralling out of control as it did in the 1970s or aggressive monetary-policy tightening would check price growth, but at the cost of a painful recession. Neither scenario looked pretty.
What came to pass was different. Inflation drifted back to earth without a significant downturn in either country. Interest rates have now started to fall.
This came into focus over the past week. On Tuesday, Statistics Canada reported that the annual inflation rate touched the Bank of Canada’s 2-per-cent target in August for the first time since February, 2021. The following day, the U.S. Federal Reserve kicked off its cutting cycle with an unusually large half-percentage-point move – lowering the range for its federal funds rate to 4.75 per cent to 5 per cent – and signalled more rate cuts are to come.
The back-to-back events mark a milestone for the North American economy. The situations are different in Canada and the United States, but both countries appear to be on track for a “soft landing,” where price stability is restored without a recession or widespread layoffs.
That’s allowed the Bank of Canada and the Fed to start recalibrating monetary policy for the next phase of the economic cycle, where inflation is no longer an all-consuming menace and other issues – such as trade wars, government deficits, productivity and artificial intelligence – could take centre stage.
“This is really planting the victory flag in the battle against inflation,” Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce, said of the jumbo rate cut from the Fed.
Central bankers aren’t declaring mission accomplished quite yet. In Canada, headline inflation hit the bullseye in August, thanks in part to falling oil prices. But it is expected to fluctuate around the target in the coming months, and measures of underlying price pressures remain several notches above 2 per cent. In the U.S., headline inflation is still hovering around 2.5 per cent.
That said, both central banks clearly see the finish line, and want to get borrowing costs down to a more neutral level fairly quickly before they do undue damage to employment and overshoot the 2-per-cent inflation target on the way back down. That opens the door to larger rate cuts from the Bank of Canada, which has so far delivered three quarter-point cuts since June, bringing its policy rate to 4.25 per cent.
“At least for the Bank of Canada, it kind of stuck the landing,” said Beata Caranci, chief economist at Toronto-Dominion Bank.
The Fed, by comparison, seems to be behind the curve on cutting interest rates, she said. Given the decline in U.S. inflation and the softening in the labour market, their policy rate “should probably be right now at about 4 per cent not 5 per cent,” she said.
The speed at which inflation rose in 2021 and 2022 caught central bankers around the world by surprise and put monetary policy on a back foot.
By the same token, the decline in inflation has happened faster than many expected. After peaking at 8.1 per cent in Canada and 9.1 per cent in the United States in June, 2022, inflation has marched steadily lower, with a few hiccups along the way. Compared with the last inflationary surge in the 1970s and 1980s, this episode has passed relatively quickly and the comedown has been much less painful.
“We don’t really have a historical precedent for this. So that in itself makes it a big deal,” Ms. Caranci said.
She chalked this up to several things. Inflation was driven up by a combination of pandemic-related factors, including supply chain disruptions, abrupt shifts in consumer-spending patterns and unprecedented government transfers to households. There was also a commodity price shock caused by Russia’s invasion of Ukraine, and a period of extreme labour-market tightening as pandemic restrictions were removed and demand for workers outstripped supply.
As these dynamics have faded, upward pressure on prices and wages have eased, Ms. Caranci said.
Central-bank rate increases also played a part, dampening consumer demand and keeping inflation expectations anchored. Unlike in the 1970s, most businesses and consumers never came to expect inflation would remain high over the long run. That’s important given how inflation expectations influence wage bargaining and price-setting behaviour.
“I think it was clear to people that the central bank was going to do what they needed to do to bring inflation back down,” said Jeremy Kronick, director of the centre on financial and monetary policy at the C.D. Howe Institute.
The question remains: Why didn’t the aggressive rise in interest rates do more damage to the economy as a whole?
In Canada, the answer is tied to population growth. A huge surge in temporary immigrants kept the overall size of the economy growing even as gross domestic product per capita has declined for the better part of two years. The rapid rise in unemployment, which has taken steam out of the labour market, is largely because job creation has failed to keep up with population growth. Actual layoffs have been muted.
Meanwhile, the U.S. economy seems to have shrugged off higher interest rates for several reasons. Many American homeowners have 30-year mortgages, making them much less sensitive to changing interest rates. Consumer demand has also been propped up by massive levels of government spending, both during the pandemic and afterward.
“Fiscal policy gets a lot of blame for the inflation that came out of it, and I think rightfully so,” Mr. Kronick said. “But governments also should get credit for what they did during the pandemic itself. They really did pull people through and gave them a fair amount of savings that I think allowed them to work their way through this higher-interest-rate period.”
There are still downside risks ahead, especially for the Canadian economy, which will see a wave of mortgage renewals over the next two years that could further squeeze homeowners and weigh on discretionary spending. If central bankers don’t normalize interest rates quickly enough, they may still botch their soft landing.
But with inflation back near target and interest rates moving down in both Canada and the U.S., the economic narrative has begun to shift. The two speeches Bank of Canada governor Tiff Macklem has given this month have been on trade and artificial intelligence. In both, the current level of inflation was an afterthought.