What is the Bank of Canada trying to (re)gain? His credibility or our trust?
With inflation at 6.8% in April, as expected, the Bank of Canada raised the policy rate by an additional 50 basis points on June 1. The benchmark rate now stands at 1.5%, just a quarter of a percentage point lower than its pre-pandemic level.
While concerned about domestic inflation, the Bank recognizes that inflation is primarily a global problem—not a Canadian problem. Indeed, in addition to “the Russian invasion of Ukraine, COVID-related lockdowns in China, and ongoing supply disruptions,” the bank alleges that excess US aggregate demand is also contributing to higher inflation. world, thereby increasing inflation imported from Canada. And of course, as the bank well knows, imported inflation cannot be affected by increases in domestic interest rates.
But to justify the hike in interest rates, the Bank of Canada also says the Canadian economy is “clearly operating on excess demand,” with GDP growing at an annualized rate of 3.1% in the first quarter of 2022. evidence, however, is inconclusive.
For starters, first quarter growth was well below analysts’ expectations of 5.4% and also lower than the 6.6% posted in the previous quarter. More importantly, while nominal wages are on the rise, the year-over-year rate is well below the rate of inflation, falling from 3.4% in March to 3.3% in April.
Therefore, if there was excess demand in the Canadian economy, it would not be significant, declining, and primarily concentrated in the cooling housing market. And in any case, while a 50 basis point interest rate hike can have a significant impact on the housing market, it will have a negligible effect on CPI inflation.
However, although the interest rate cannot be used as a magic wand to fight inflation, the Bank of Canada had no choice but to raise the key rate to save its credibility, which has recently been questioned by many experts and some politicians. And its credibility rests on the belief of the public – or the markets – that the bank will always use monetary policy – that is, change the key rate – to keep the inflation rate on target.
But, of course, its credibility also depends on the success of the political decision, ie a rise in interest rates leading to a fall in inflation. But even if the recent increase in interest rates may not have the desired effect, it still gives the bank some extra time for inflation to come down on its own as commodity markets stabilize and supply chain disruptions are resolved – and, of course, as inflationary imports decline, the Bank of Canada will take credit and salvage credibility.
In my opinion, even more than by trying to restore its credibility by raising the key rate, the Bank of Canada is trying to regain our confidence in the bank. It is a crucial problem. Indeed, the importance of building trust and credibility in the bank was emphasized by Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, in a major speech on May 3.
However, the title of the speech published on the bank’s website was “Bank of Canada: A Matter of Trust”, and while the word “credibility” appeared only twice and without any qualification, the word “trust” was repeated 15 times and its relevance explained.
Surely the bank knows its credibility is at stake unless it raises interest rates and cuts inflation accordingly. But while the political decision is in the hands of the bank, its success is beyond its control. And higher interest rates, the bank knows, cannot reduce inflation unless they are raised to levels above the rate of inflation – so that real rates become positive – and cause a deep recession in the process.
I hope that the bank intends to avoid this possible negative outcome and therefore does not raise the key rate to levels close to the rate of inflation. In short, aware of its inefficiency, I believe that the bank will not make full use of the interest rate in its fight against inflation.
For this reason, it seems that the bank is trying to gain our trust, our confidence that it will do “whatever it takes” – as Italian Prime Minister and former European Central Bank President Mario Draghi said when the future of the euro was at stake — to preserve Canada’s financial and economic well-being, even at the cost of temporarily above-target inflation.
In Draghi’s case, he was able to regain the confidence of the markets without having to describe the policy tool supposedly contained in the “all it takes” statement. But it is different for the Bank of Canada since it has no other tool than the interest rate to fight against inflation. And it is for this reason that I consider that today’s inflation is not — and cannot be — work for the Bank of Canada.