A person walks past the Bank of Canada headquarters in Ottawa, on June 1, 2022.Adrian Wyld/The Canadian Press
This week’s inflation numbers could hardly have been more encouraging. The headline 12-month rate fell to 2.8 per cent in June: lower than expected, and within the Bank of Canada’s 1- to 3-per-cent “control range” for the first time since March, 2021.
This was not just a statistical artifact, a reflection of year-ago price increases dropping out of the calculation. Inflation over the past three months was an annualized 2.6 per cent; take out food and energy, and it slips further, to 2.5 per cent.
Canada’s inflation performance looks even better when you compare it with other countries. Inflation rose everywhere coming out of the pandemic, and spiked higher after Russia invaded Ukraine. But inflation here peaked lower (8.1 per cent) and sooner (June, 2022) than in all but a handful of OECD countries, and has likewise fallen further than all but a handful. Guess we better fire the governor.
All this, and still no sign of the long-feared recession. Interest rates may have been hiked 10 times in the past year and a half, but unemployment still sits at 5.4 per cent, not far off its historic lows, while the employment rate, at 62.2 per cent, remains higher than it has been at most times since 2008.
So: Inflation has fallen further than expected, faster than expected, at less cost to the real economy than expected. If the news is so good, why is everyone so glum? Well, almost everyone: Finance Minister Chrystia Freeland greeted inflation’s return to the 1- to 3-per-cent range (often erroneously described as the bank’s target; in fact the target is 2 per cent) as a “milestone moment” and posted a tweet (“Canada’s plan to bring down inflation is working”) taking credit for it, baselessly.
Apart from her, however, the reaction was strangely muted. “The bank has not won its inflation battle yet” was a typical headline; “The bank can’t get too excited” was another. Not that there was much danger of that. Just the week before, as it imposed its latest interest-rate hike – at 5 per cent, the bank’s policy rate now stands at a 22-year high – the bank warned that it might not be done raising rates yet.
The reason: The various measures of “core” inflation the bank uses to help it steer toward its target were still flashing yellow. “CPI-trim,” for example, which strips out the most volatile items, remains at about 4 per cent, on a three-month annualized basis, where it has been since the year began. “Core” service-sector inflation, excluding shelter costs, is nearer to 5 per cent. Inflation will not return to 2 per cent, the bank warned, for another two years.
Predictably, the bank has lately been hearing from the usual quarters asking: Is this trip necessary? Why raise rates still further – why raise them as high as you have – just to grind that last percentage point out of inflation? Isn’t it time to just declare victory and get out?
Leave aside that 2-per-cent inflation is not only the bank’s target, but its legally mandated objective. Leave aside, too, the vast body of research showing lower, stabler inflation – 2 per cent or less – leads to better economic results than higher, more volatile inflation.
What should we make, rather, of the premise, which the bank seems to share: that while inflation may have fallen relatively quickly and painlessly to date – from 8 per cent to 3 per cent, in the space of a year – getting from 3 to 2 will be like the Battle of the Bulge?
Let me suggest why it might not. When people talk about the economic cost of curbing inflation, they tend to have past experience in mind. And it’s true that the fight against inflation has often proved painful in the past. Recessions and rising unemployment seemed to be the inevitable result, raising the question of whether the cure was worse than the disease.
Why hasn’t it cost as much this time? For the same reason it proved so costly in the past: expectations. Past inflations were hard to extinguish because people expected them to continue. They had good reason to do so, after all. Inflation first became a fixture in the 1960s, and for most of the next three decades it continued – indeed, it accelerated.
High and rising inflation did not happen by accident. It was the consequence of policy. Postwar policy makers had been convinced they could purchase lower unemployment at the cost of higher inflation. After all, there were data to suggest a correlation between the two: the famous “Phillips Curve.” Surely this was more than mere correlation. Surely it was not just a statistical relationship, but a causal one.
What they hadn’t counted on was how repeated doses of inflation would work their way into expectations. Inflation might reduce unemployment if you could “fool the workers” – if inflation rose faster than wages, then the real cost of labour to employers would fall, and the demand for labour would rise.
But if workers got wise to the game, and demanded higher wages to compensate for higher inflation, then all you’d get in the end was high inflation and high unemployment. Which is indeed what we got.
Worse, once expectations of inflation had become so firmly entrenched, they turned out to be extremely difficult to dislodge. Expecting continued inflation, people continued to demand higher prices and wages, only finally being convinced otherwise by the hard remedy of recession and unemployment. The Phillips Curve, it turned out, worked only in reverse.
But this inflation is an altogether different thing. Indeed, it is unprecedented: certainly in Canadian history, maybe in human history. For this inflation, uniquely, comes on the heels of a 30-year period of low and stable inflation. From 1992 through 2021, inflation averaged less than 2 per cent, annually. More impressively, it almost never strayed even briefly above 3 per cent: less than 6 per cent of the time.
That experience seems to have stuck with people. The surge in prices of 2021-22 may have shaken people’s faith in the short term, but long-run expectations of inflation remained firmly “anchored,” as central bankers like to say.
We can tell this from looking at what’s called the “break-even” inflation rate: the difference between the yield on conventional and inflation-adjusted bonds. Throughout the past two years, while inflation raged, it has remained resolutely below 2 per cent. Consensus forecasts of economists have been similarly stolid.
If expectations that inflation would continue made it hard to reduce inflation in the past, expectations that inflation will subside are making it easier to reduce it now. Just as expectations once ruined hopes of permanently lowering unemployment in exchange for higher inflation, today they are making nonsense of predictions that lower inflation could only be achieved at the cost of much higher unemployment.
It’s probably true that the reductions we’ve seen in inflation to date represent the proverbial low-hanging fruit. Wages, traditionally the last to hear the news, may indeed take longer to complete the adjustment. But maybe not all that much longer. Average hourly wage gains have already fallen to about 4 per cent, from near 6 per cent last fall.
But we’re still left with a puzzle. If things are as hopeful as I’m describing, why is the bank furrowing its brow so conspicuously? One obvious explanation: My thesis is wrong. Or, at least, the bank isn’t convinced. But there’s another possibility: Inflation is likely to go on falling, and the bank knows it, but it doesn’t want to admit it.
Why might that be? Again, expectations are everything. And expectations aren’t only or even primarily formed from past experience. They’re also based on new information – especially information about policy makers’ intentions. Inflation might have stayed locked on 2 per cent for 30 years in the past, but if the governor of the Bank of Canada were to announce, “We’ve changed our mind: We think 8 per cent is a better number,” people would probably incorporate that into their forecasts.
That’s why you saw the bank alter its messaging in the past couple of years. There was a period there, back when high inflation seemed a distant memory, when central bankers were keen to let people know they weren’t all about price stability. They were also interested in “maximum sustainable employment” and “inclusive growth” and climate change and other things. That ended abruptly when inflation returned. Now it’s “we’re quite obsessively focused on 2 per cent, and we don’t care who knows it.”
One thing people might think would influence policy makers’ willingness to tackle inflation is the economic cost of doing so. I’ve described a scenario where inflation might be reduced at rather less cost than in the past. But what if people believe the more conventional, this-is-going-to-hurt scenario? What if they begin to wonder whether central bankers are willing to inflict that kind of pain on people? If so, they might expect the bank, whatever its firm-sounding targets and declarations of resolve, to flinch in the end.
In which case they would go on demanding higher wages and prices. In which case they might increase the likely cost of disinflation. In which case they might be more confirmed in their belief that the bank would ultimately lose its nerve. And so on: a perfect circle of self-fulfilling expectations.
So the bank has to persuade people it has the stomach for the fight. It’s not enough just to set a target. It has to be a hell-or-high-water target. The worst way to do that is to issue an optimistic “all is fair-weather” forecast. You have to predict tough slogging ahead – to show that you are determined to soldier on through it.
We’ll see what happens. But inflation has beaten expectations to this point. Don’t be surprised if it beats expectations again. Mind you, I suppose if you expect it to beat expectations …