Bank of Canada Governor Tiff Macklem. The more inflation gets out of hand, the more aggressive central banks may have to be if they want to snuff out the threat.BLAIR GABLE/Reuters
One perk (or, perhaps, curse) of my job is that I get an enormous amount of economic research e-mailed to me every day – commentary and reports from bank economists, investment strategists, independent research firms and think tanks flow in by the dozens each day. It provides a great way to detect shifts in the prevailing winds of opinion.
In the past week or so, they’ve shifted pretty hard. Recession is suddenly, unmistakably in the air.
A quick sampling from the past 48 hours or so:
“Clearly, the risk of a recession has increased,” said Kristina Hooper, chief global market strategist for U.S.-based investment firm Invesco Ltd.
“There is no limit to how high the Bank of Canada can raise interest rates, and there is no limit to how far those increases can push the economy into recession,” Concordia University economist Moshe Lander said.
“We aren’t suggesting a recession is imminent, but the probability of a [monetary] policy error is increasing. … We are highlighting the increased probability of a growth accident occurring,” wrote Ian Pollick, head of fixed income, currency and commodities strategy at CIBC Capital Markets in Toronto.
Did we miss something? Last time we looked, economists were still talking about Canadian growth in 2022 of close to 4 per cent. Large segments of the services sector were expected to ramp back up to speed as the COVID-19 pandemic faded, opening up new avenues for growth. People were worried that central banks were behind the curve, and would have to raise rates sooner and faster to cool a heating economy and rein in inflation.
What has quickly changed is the emerging realization that the war in Ukraine, even if it can be contained, has sparked an economic isolation of Russia that is about to send already high inflation into the stratosphere. The growing risk is that soaring prices – especially for key fuel and food commodities, strains that consumers can’t miss and can’t avoid – will become a major drag on spending, by both sapping spending power and undermining confidence.
“At some point, the speed and size of rising commodity prices will lead to levels that will cause demand destruction,” prominent economist David Rosenberg, head of Rosenberg Research in Toronto, said in a note to clients on Wednesday.
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At the same time, those rising prices add to the already intense pressure on central banks – in Canada, the United States and elsewhere – to ramp up interest rates in an effort to wrestle inflation back down. The more inflation gets out of hand, the more aggressive central banks may have to be if they want to snuff out the threat.
The combination, more and more economists now fear, could deliver a harder stomping on the economic brakes than they had previously anticipated.
“What keeps me sweating in the middle of the night is knowing we are heading towards a point where high inflation will restrict consumption, and yet [interest-rate] policy will still need to tighten. That is the accident that may ultimately trigger the next downturn,” Mr. Pollick said in an interview via e-mail on Wednesday.
The problem for central bankers is that they simply can’t afford to let inflation expectations take a large and permanent shift higher. They need to maintain confidence that inflation can be returned to long-standing targets of about 2 per cent. Faith in inflation stability is crucial to maintaining a healthy economy.
The risk of those expectations going adrift has become a lot more real as the Ukraine conflict has set oil prices on fire. The Bank of Canada and other central banks may soon face an unpleasant choice: either let inflation run hot in order to sustain growth, or snuff out growth with aggressive rate hikes in order to stamp inflation back down to where they want it.
Frankly, in the long run, the latter may be the wiser choice. A loss of confidence in the ability or willingness of central banks to tame inflation would be a longer-lasting threat to our economic well-being than a couple of quarters of contraction. Maintaining that confidence in inflation targets almost certainly will, and absolutely should, take priority for the Bank of Canada.
It might not come to that. Even if the war in Ukraine and the resulting added inflation do weigh on demand, they arrive at a relatively healthy time for the Canadian economy. The drag on growth will be at least partly offset by the much stronger prices for Canadian energy exports, which will considerably increase the contribution to national income from the oil and gas sector.
The huge glut of consumer savings that have built up over the pandemic – estimated at about $200-billion in Canada, perhaps $5-trillion-ish globally – could serve as a major shock absorber, helping sustain demand. The expected return of many services as pandemic restrictions continue to ease will deliver opportunities to spend those savings. The resurgence of the services sector could also take considerable pressure off goods industries, helping alleviate the supply crunches that fed the current inflation problem in the first place.
In that case, maybe central banks won’t have to choose between cooling inflation and maintaining growth. But threading that needle has become a lot trickier than it looked even a few weeks ago.
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