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On a year-over-year basis, inflation fell 50 basis points in July — to 7.6 per cent from 8.1 per cent the previous month. This is a significant one-month decrease — sufficient to convince some pundits that the process of monetary tightening the Bank of Canada started in March might already be showing promising results. This drop in inflation even allowed some analyst to speculate that the September policy rate increase would be the Bank’s last for this year.
But on Wednesday the Bank of Canada threw a bucket of cold water on this cheerful view. As expected, the Bank did increase its target for the overnight rate by 75 basis point, but also stated unequivocally that “the Governing Council still judges that the policy interest rate will need to rise further.” And, consistent with what Bank of Canada governor Tiff Macklem expressed in an August opinion piece in the National Post, the Bank added that it “will continue to take action as required to achieve the two per cent inflation target.”
So before celebrating any apparent Bank of Canada success in the fight against inflation, it seems prudent to take a pause and examine the data in some greater detail.
As a starter, the drop in inflation appears to be entirely the result of a 9.2 per cent decrease in the price of gasoline in July — though still being 35.6 per cent higher than a year earlier. And the price of gasoline depends mostly on the price of oil, which is determined in international markets and thus it’s not affected by changes in domestic interest rates. So definitely, the Bank of Canada cannot take credit for the fall in gasoline prices and the corresponding decrease in the rate of inflation.
Further, on a month-on-month basis, the average price of the goods and services included in the consumer price index (CPI) basket increased slightly in July — that is, the deflationary effect of the drop in gasoline prices was not sufficient to outweigh the inflationary impact of price-increases in other components of the basket. Indeed, excluding gasoline, year-over-year inflation rose from 5.5 per cent in June to 6.5 per cent in July — particularly due to an annualized increase of 11.1 per cent in food prices. Moreover, on a month-on-month basis, core inflation — which excludes both energy and food — rose in July at an annualized rate of 7.9 per cent compared to 5.2 per cent in June.
Therefore, it seems that the successive increases in interest rates have not yet had much of an impact on domestic sources of inflation. And this should come as no surprise for two reasons.
On the one hand, higher interest rates are supposed to reduce aggregate demand, but today’s domestic inflation is not due to excessive demand. Rather, the source of today’s domestic inflation appears to be the result of firms taking advantage of their market power in a general environment of rising prices. Therefore, even if demand were to be reduced, its short-run impact on inflation would be rather negligible anyway.
On the other hand, even after this week’s increase, the rate of interest is still too low to have any noticeable impact on demand and inflation. Indeed, interest rate hikes to date may be having a considerable effect on the housing market, but they do not seem to have affected consumption expenditure in any significant way yet.
Of course, to justify the interest rate hikes, the Bank of Canada is trying hard to convince Canadians — as did Macklem in his August opinion piece — that “our economy continues to operate in excess demand.” Hence, “we need to slow down spending to allow supply time to catch up with demand and take the steam out of inflation,” Macklem wrote. Well, perhaps the bank should be reminded that repeating this “excess-demand” assertion time and again will not be sufficient to making it true.
In any case, we should keep in mind that the bank’s interest rate hikes are not ultimately intended to reduce average prices, but rather to slow down the economy to increase unemployment. In other words, the intention is to reduce workers’ bargaining power so wage increases would come shy of the increase in prices. In the end, the goal is to prevent the emergence of inertial inflation — that is, to prevent inflation from becoming entrenched and resulting in a wage-price spiral.
And this is a political — not technical — decision. Indeed, the government allows firms to increase prices to raise their profits but calls on the Bank of Canada to implement contractionary monetary policy to inhibit workers from restoring their wages’ purchasing power. This way, the wage-price spiral is cut short at a cost mostly to workers in the form of higher unemployment and lower real wages.
And this objective has not yet been secured. Although the pace of wage growth is still lower than inflation, it is nonetheless picking up. Indeed, on a year-over-year basis, average hourly wages increased 5.2 per cent in both June and July, compared to 3.9 per cent in May and 3.3 per cent in April. Therefore, as expressed in its Wednesday statement, the Bank of Canada is not about to take a pause and keep the policy rate at the current 3.25 per cent for some time.
It seems the Bank of Canada has no choice but to continue raising the interest rate for another reason as well: since inflation has not been tamed yet, the bank must increase the policy rate in an effort — no matter how futile — to regain its wounded credibility. Indeed, the general belief is that maintaining price stability is a job for central banks: if there is inflation, the rate of interest must be raised; and if there is deflation, the rate of interest must be reduced. This is what’s expected from central banks, and their credibility depends on it — despite the fact that reducing the policy rate to even below zero per cent was not sufficient to eliminate deflationary pressure in Japan and many European countries in the advent of the Great Recession.
Therefore, the Bank of Canada will definitely continue raising the policy rate — even though the latest data shows the Canadian economy contracting slightly in July. Indeed, this slowdown is not sufficient to prompt the Bank of Canada to a pause — a deeper recession is certainly needed to restrain workers’ demands for the restoration of their wages’ purchasing power.
How high will interest rates go? Hard to say — but certainly higher than the 3.75 to 4.0 per cent most pundits are forecasting for the end of the year. Once again, making use of my crystal ball, I would predict that the policy rate will be raised to somewhere between four and 4.5 per cent by December — and further until at least the second quarter of 2023.
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