Another Hike

Economists expect that the Bank of Canada will raise interest rates today. Craig Alexander writes:

The Bank of Canada is struggling to get inflation back under control. Since it adopted inflation targeting in the early 1990s, the central bank has been remarkably successful at keeping inflation within its 1-per-cent to 3-per-cent-target band. Indeed, the average pace of inflation over the decades has been almost bang on the 2-per-cent midpoint target. However, the inflationary pressures from the contraction in global supply during the pandemic and the surge in demand as government restrictions lifted caught the Bank of Canada and many other central banks flat-footed.

The current inflation shock shows Canadians just how critical it is to keep inflation low and stable. High inflation materially damages the standard of living of Canadians and is especially crippling to low-income Canadians that lack savings they can draw upon to buy even the most essential of products. This is why the bank has aggressively raised interest rates to wrestle price growth down, and why financial markets expect another rate hike on Wednesday – hopefully the last one.

What the Bank's actions signal is that the era of low-interest rates is over:

Interest rates trended downward over the 1990s and early 2000s before plunging to exceptionally low levels during the financial crisis in 2008 and 2009. Importantly, they remained minimal even after that crisis. This fuelled excessive investment in real estate and dramatically increased debt accumulation. It forced investors to buy more equities because fixed-income investments lacked adequate yield. It allowed businesses to put off making capital investments because there was no expectation that interest rates would rise significantly in the future.

The low-interest-rate era was supported by the disinflationary force of globalization that shifted production to lower-cost parts of the world that, in turn, reduced consumer prices. It made the job of keeping inflation subdued much easier for central banks and contributed to perpetually low interest rates.

However, in the wake of the pandemic and amid the tensions with China and Russia, businesses are now shifting their supply chains to build resilience and reduce risk. Future capital investment will be determined by more than just the cost of production, including geopolitical risk and ESG considerations. This will raise prices and make it harder for central banks to control inflation.

Moreover, the aging population across the Western world, including Canada, and the retirement of baby boomers has started to materially affect Canada’s labour market. Immigration will take some of the pressure off, but it will not solve Canada’s labour supply and skills shortages. There will also be more international competition for talent. Labour scarcity at home and abroad should raise the cost of labour, which will be passed along to consumers with higher prices unless firms find a way to materially boost productivity.

During the pandemic, firms discovered the vulnerability of just-in-time inventory systems, in which goods are ordered from suppliers only as needed. Many firms could not meet demand from existing stockpiles. To reduce this risk, businesses may carry higher inventory levels, and this means more volatility in stockpiles as demand ebbs and flows. The greater inventory swings can add to economic volatility and, in turn, greater volatility in interest rates.

The pandemic and the war in Ukraine have changed the world. I had thought that the spike in interest rates would be temporary. I was wrong.

Image: CNBC