Central banks have made extraordinary efforts to cushion the blow of the pandemic. The most difficult thing now could be to find a way to reduce all these economic stimulus measures in order to curb inflation, but without destroying everything.
Members of the Association of Quebec Economists (ASDEQ) held their first in-person annual conference in two years in Montreal for the past two days. One of the main topics of discussion there was central banks and their chances of achieving a ‘soft landing’ after two years on the monetary accelerator.
Several participants did not hesitate to say that if inflation has been able to increase so much in recent months—to reach 6.7% in Canada in March and 8.3% in the United States in April—it is because the Bank of Canada, the US Federal Reserve and the other central banks have waited too long before recognizing the extent of the problem and are finally deciding to reform their ultra-accommodative monetary policies adopted during the crisis.
It is “in a way a lesson in humility”, admitted Thursday at ASDEQ, the deputy governor of the Bank of Canada, Toni Gravelle, in front of a graph which showed the half-dozen upward revisions of the institution’s inflation forecasts in the space of a year. From the unexpected surge in demand for goods and housing, to supply chain issues “hard to model and predict”, to the yo-yo of health restrictions, the war in Ukraine and the impact of disasters climatic conditions, it was necessary to deal with “unique and essentially global factors [qui] pushed up inflation more than expected.
New toolbox
And then, it is that the central banks did not only resort to lowering their interest rates during the darkest days of the pandemic. To respond to the rise in inflation, it was necessary to take the time to undo things in the right order, argued Sylvain Leduc, vice president and director of research at the Federal Reserve Bank of San Francisco.
Thus, the first step for central banks was to signal in their official communications (forward guidance) that reducing inflation was becoming a priority. Then, it was necessary to stop their massive purchases of government bonds and other financial assets (quantitative easing). It was only after initiating a standardization of these still relatively new intervention tools with little known effects that we could move on to the more traditional measure of raising interest rates.
This sequence of events also seems to have worked rather since long-term financing conditions on the financial markets began to tighten as soon as the forward guidance of the Fed changed, welcomed Sylvain Leduc.
As economic actors are more accustomed to following and interpreting the policies of the American central bank through the variations of its key rate, we also decided to put the spotlight on the rise in interest rates even if we will continue, at the same time, to reduce its balance sheet. However, with a value equivalent to more than a third of the American economy, these reserves of assets will have to be deflated with great caution to prevent the operation from going wrong.
Crossed fingers
Engaged in the same process as the Fed, the Bank of Canada should have reduced by 40% within two years its balance sheet of almost 500 billion. It has also raised its key rate from 0.25% to 1% since the start of the year and expects it to continue. “It takes higher interest rates to curb inflation,” said Toni Gravelle. And “the economy is able to take it,” he said.
The Bank has indicated that it wants to get closer to a “neutral” rate which would neither stimulate nor hinder the economy and which it estimates to be between 2% and 3%. But with Canadians heavily indebted and their housing market already looking set for a slight downward correction next year, Canada’s central bank may well be forced to halt before it hits the middle of that range, said warned the chief economist at Desjardins Group, Jimmy Jean, Friday at ASDEQ.
“The coming year will be full of challenges for monetary policy in the United States and around the world,” concluded Sylvain Leduc on Thursday. It’s going to take a lot of skill — and a bit of luck — to eventually bring inflation back to the 2% target without creating a recession. »