Interest rate hikes: The Bank of Canada’s ‘resolute’ fight against inflation could threaten its credibility
Ellen D. Russell, Wilfrid Laurier University
The Bank of Canada “resolutely” declared it will fight inflation by raising interest rates. To demonstrate its unwavering commitment to reaching the bank’s two per cent inflation target, today’s eighth consecutive interest rate hike brings the policy rate to 4.5 per cent. The bank expects to hold the rate for now, but is prepared to increase it again if needed to maintain its target rate.
The bank’s logic is this: when demand outpaces what the economy supplies, the result is inflation. Based on this analysis, the Bank of Canada raises interest rates to “dampen demand so supply can catch up.” Using interest rates to fight inflation has been central banks’ boilerplate approach for years.
Higher interest rates deliberately slow the economy by discouraging borrowing. In a slowing economy, labour demand eases and job vacancies decline. This is a bitter pill to swallow for those already struggling to make ends meet, since deliberately encouraging higher unemployment exerts downward pressure on wage growth.
Why does the central bank emphasize how resolutely committed it is to raising interest rates? In central banker lingo, this is called jawboning or forward guidance.
Jawboning is communication intended to influence the expectations of the public. As Ben Bernanke, former chairman of the United States Federal Reserve, once explained — when he could talk more freely after leaving the bank — “monetary policy is 98 per cent talk and only two per cent action.”
By emphasizing its steadfast commitment to lowering inflation, the Bank of Canada hopes to persuade the public to expect lower inflation.
The bank is eager to influence our expectations about inflation because expectations can be self-fulfilling. If we expect future price increases, we are likely to bid up prices (and seek higher wages) in anticipation of impending price hikes.
If the Bank of Canada convinces us that it can and will beat inflation, we are more likely to refrain from actions that bid up prices, and thereby support the bank’s fight against inflation.
But central bank influence on expectations is a double-edged sword. As Bernanke writes:
“The ability to shape market expectations of future policy through public statements is one of the most powerful tools the Fed has. The downside for policymakers, of course, is that the cost of sending the wrong message can be high.”
Jawboning only dampens inflationary expectations if the public has faith that the Bank of Canada is credible in its analysis and actions. But do we believe that raising interest rates is the right tool to control inflation?
Beyond the central bank’s control
As the bank itself acknowledges, there are other causes of inflation, such as the war in Ukraine and supply disruptions caused by the pandemic. These issues will not be solved by increasing interest rates.
Arguably, the public worries about many inflation causes that are beyond the Bank of Canada’s control. For instance, Canadians may be concerned about “greedflation” that occurs when large companies exploit their extensive market power to boost prices excessively.
The recent Parliamentary inquiry and Competition Bureau study of competition among grocery stores was prompted by the possibility that food costs are impacted by this lack of competition.
The central bank has little control over many factors impacting inflation, such as extreme weather in areas that export food and raw materials to Canada. There are also longer-term supply challenges with inflationary repercussions.
Climate change and inflation
Consider the future implications of the war in Ukraine and other geopolitical instability. Globalization has been extolled for keeping costs down, but global supply chains are vulnerable to disruption by anything from the COVID-19 situation in China to ships getting stuck in the Suez Canal.
To protect supply chains, companies may onshore or ‘friendshore’ by moving production to locations viewed as more insulated from international turbulence. This could exert upward pressure on prices if it requires building new facilities in higher-cost areas.
Climate change also influences inflation. It may reduce crop yields, for example. But fighting climate change also impacts inflation over the longer term. Living up to our climate commitments requires the transformation of energy production, manufacturing and transportation. This will be expensive.
Ironically, higher interest rates may further increase the costs of responding to climate change, localizing supply chains and other longer-term challenges. Building new production, transportation and other infrastructure takes funding, and higher interest rates makes it more expensive to borrow money to invest in restructuring.
Given the array of publicly visible factors contributing to inflation, the Bank of Canada needs to consider the possibility that the public will not be persuaded that their approach to inflation fits these unprecedented times.
Effective jawboning requires credibility. This credibility is based on the public’s belief that the central bank is using the right tools for the job. The Bank of Canada does not want to appear to be suffering from Maslow’s hammer — a bias against trying more appropriate tools because, as the saying goes, “if you only have a hammer, everything looks like a nail.”
Ultimately, the reputation of the Bank of Canada will be undermined if the public believes that it’s pounding away with a hammer that is not needed and causing much hardship in the process.
If the bank loses credibility, the public may conclude this hammering is preventing us from pursuing more constructive options. Paradoxically, inflationary expectations could be fuelled if the public believes we are relying on the wrong tool while neglecting better ones that might get the job done.
This is not to say that inflation has an easy fix. We may require all sorts of policy responses that are far beyond the Bank of Canada’s purview.
But so long as policymakers subscribe to the boilerplate analysis that concludes the hammer is the only tool worthy of consideration, we leave our whole toolbox on the shelf while the Bank of Canada behaves as though the only problem is a nail.
Ellen D. Russell, Associate Professor, Faculty of Liberal Arts, Wilfrid Laurier University
This article is republished from The Conversation under a Creative Commons license. Read the original article.
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