BoC must raise rates — gradually
When reading the business sections of major newspapers, one gets the impression that inflation is the No. 1 economic preoccupation for most Canadians.
Yes, inflation has increased in the past few months above the Bank of Canada’s two per cent target, and now stands at 4.8 per cent. But is this high inflation? The short answer is no, it’s not — and certainly it’s not hyperinflation.
And although today’s inflation rate stands at a 30-year high, it’s still much lower than the 12 per cent Canada experienced in the early 1980s.
So, why all the fuss?
For starters, most economists believe the current increase in inflation is temporary, and mostly due to supply-chain bottlenecks spurred by the pandemic.
It seems the Bank of Canada shares this view and, thus far, has resisted pressure to raise its key interest rate to fight inflation. Yet the pressure is getting stronger by the day.
But is raising the rate of interest the right policy at the present time? Should the Bank have increased its key interest rate last Wednesday? Well, yes and no.
In my view, the rate of interest should not be increased to fight inflation, but rather to help reduce the current situation of financial fragility in the economy.
Why should a rate hike not be used to fight current inflation? According to conventional theory, an increase in the interest rate would reduce aggregate demand, particularly consumption demand.
In turn, lower aggregate demand would translate into higher unemployment — thus reducing workers’ bargaining power when negotiating new wages.
In other words, higher interest rates would reduce future wage increases, that is, reduce future increases in labour costs of production.
But prices are not set by workers, they are set by firms. Indeed, firms set higher prices to offset the impact of higher costs of production on their profit.
But does it make sense to reduce aggregate demand (and employment) when there is a consensus that current inflation is mostly due to supply-chain bottlenecks?
That is, does it make sense to reduce labour cost of production to offset cost increases due to supplychain disruptions? Certainly not.
If we are not experiencing wagepush inflation, raising interest rates is definitely the wrong approach to fighting inflation.
Further, to be effective, fighting inflation in this way would require a significant increase in the key interest rate.
Indeed, a gradual increase of 25 basis points every three months or so would not do it — it would need, say, a sudden increase of 100 basis points or more. Why? Because expectations of inflation need to be lowered for inflation to be permanently reduced, and this might require a significant increase in unemployment — that is, a deep recession — to bring down workers’ demand for compensatory higher wages.
But workers’ wage demands are not the source of today’s inflation: average salaries have increased by only 2.8 per cent in 2021, and a similar increase is expected in 2022.
So, higher rates of interest are definitely not needed to reduce today’s source of inflation — and thus, in this sense, the Bank’s decision Wednesday to keep its key policy rate unchanged at 0.25 per cent was the right policy choice.
In any case, for some time, low interest rates appear to have simply compensated for the negative impact of greater income inequality on consumption expenditure.
Indeed, despite productivity increases, average real wages have remained relatively stagnant since the 1980s, while consumption expenditure has stayed strong all along thanks to greater households’ indebtedness — thus contributing to the creation of a situation of financial fragility in the economy.
In this regard, the evidence seems quite clear: The ratio of household debt to disposable income increased to 180 per cent by the end of 2021 from 88 per cent in 1990. And this situation is unsustainable. It’s a sign of a financial crisis in the making since a sufficient increase in unemployment — or in interest rates — could cause many loans to become unpayable.
But most importantly, together with the implementation of unconventional monetary policies such as quantitative easing, low rates of interest have fostered speculative behaviours and the formation of bubbles in asset markets — thus further worsening the situation of financial fragility.
Here the evidence is also quite clear: Over the past five years, low interest rates have contributed to more than 50 per cent increase in the price of houses, and a similar surge in the stock market index. And again, this is clearly unsustainable: it’s definitely a sign of a financial crisis in the making.
In short, there exists at the present time a high risk of a financial crisis, and this should be the Bank’s main concern rather than the temporary higher rate of inflation.
What should be done to reduce the risk of a financial crisis similar to the one the U.S. experienced in 2008? In other words, what should be done to prevent the bursting of the present bubbles in the housing and stock markets?
First of all, efforts should be made to strengthen the regulation of the financial system to reduce speculative behaviours and prevent further increases in asset prices.
Second, the Bank should immediately halt its monthly purchases of debt securities, since quantitative easing just injects cash in the hands of investors, thus fuelling speculative behaviours and causing the growth of asset bubbles.
And finally, beginning in March, the key rate should be increased — but gradually — say, by 25 basis points every three months or so, as was done from July 2017 to October 2018.
But of course, we don’t live in a bubble, and thus the timing of future interest-rate increases should be done in tune with the Federal Reserve to avoid a possible overvaluation of the loonie.
So yes, the Bank of Canada should increase the rate of interest — if not to fight inflation, certainly to ease the situation of financial fragility in the economy.
But it should do so very gradually over time.
This way, interest-rate increases would not cause a recession, since their short-run impact on aggregate demand would be rather negligible, while at the same time helping to reduce speculation in asset markets without causing the present asset bubbles to burst.