(Ottawa) Canadians are seeing the cost of borrowing rise rapidly as the Bank of Canada takes historic steps to slow soaring prices, after learning costly lessons from history when central banks gave free rein to inflation.
Posted at 7:11 a.m.
The Bank of Canada recently raised its key interest rate by a full percentage point – its largest single rate hike in more than two decades – as it tries to cool domestic demand and lower expectations for ‘inflation.
An unusual decision for an unusual time: annual inflation hit 8.1% in June, a 39-year high, after years of seeing the consumer price index remain stable and predictable in Canada.
But for most of the 20th century, price stability was not a given in the Canadian economy.
TD Bank Chief Economist Beata Caranci pointed out that if inflation may seem particularly difficult today, it’s because Canadians have been shielded from its volatility for decades.
“We haven’t had this challenge for a while,” noted M.me Depleted.
A “significantly different” approach
Canada’s last experience with high inflation came in two waves during the 1970s and 1980s. In particular, it peaked at 12.9% in 1981.
In 1973, adverse weather conditions triggered a global food shortage, and an Organization of the Petroleum Exporting Countries (OPEC) oil embargo drove up energy prices. Several years later, a second energy crisis was caused by the Iranian revolution of 1979.
And even if the drivers of high inflation remain relatively similar – global circumstances driving up food and energy prices – current inflation is unlikely to climb as high or be as persistent.
This is because the approach of central banks is now markedly different, explained Stephen Williamson, professor of economics at Western University.
“A big difference is that there’s now a sort of entrenched notion that it’s primarily the Bank of Canada’s job to do inflation control,” Williamson said. In the 1970s, that was not true. »
For most of the 20th century, central banks had yet to develop strong and effective mandates to maintain a stable reading of inflation, Williamson continued. Instead, they were trying to control inflation through the money supply.
Economists at the time believed that inflation could be managed by controlling the amount of money circulating in the economy. However, central banks have found this tactic unsuccessful.
Mme Caranci explained that if the Bank of Canada was slow to intervene this time, it was partly because central banks have always been reluctant to hinder economic growth by raising interest rates.
TD Bank economist James Orlando wrote an analysis in April comparing today’s high inflation to that of the 1970s and 1980s. He noted that the Bank of Canada was slow to raise interest rates in the 1970s. 1970 and that by the time she acted it was too late.
“Inflation expectations adjusted upwards, leading to even higher inflation in subsequent years,” Orlando said.
Interest rates in the 1980s eventually reached 21%.
Several differences in play from one era to another
In 1982, the Bank of Canada announced that it would no longer target the money supply and instead focus on interest rates.
Canada’s turbulent experience with high inflation also led to the Bank of Canada’s mandate to maintain a target for rising prices. In 1991, the Bank of Canada and the Minister of Finance agreed to an inflation control framework to guide monetary policy.
“We believe the Bank of Canada has learned from history,” Orlando wrote in his comparison of inflation in the two eras.
This time around, Canada’s central bank is still under fire for taking too long to start raising its key rate. By comparison, however, the Bank of Canada has acted more quickly and with greater vigor than in the past.
“We hear today a different discourse coming from the central bank, according to which there is a will to sacrifice growth, and even to increase the unemployment rate”, underlined Mr.me Depleted.
In its latest interest rate announcement on July 13, the central bank delivered a clear message: it is not afraid to act aggressively to curb soaring inflation.
At the same time, economists like David MacDonald of the Canadian Center for Policy Alternatives have used history to warn that raising rates too quickly could trigger a recession, as happened in the 1980s.
However, M.me Caranci said there were significant differences between the two periods, including a different composition of the economy and the existence of safeguards such as mortgage stress tests.
“The difficulty with comparisons between periods, especially when you go back so far in history, is that there are several differences at play,” explained M.me Depleted.
In May, Bank of Canada Deputy Governor Toni Gravelle delivered a speech emphasizing why comparisons between stagflation in the 1970s and the current inflation environment were “unjustified”. He notably mentioned strong economic growth, a tight labor market and historically low unemployment.
Most importantly, Mr. Gravelle indicated that today’s Bank of Canada has the policy tools it needs to control inflation.
“Since the 1990s, the Bank of Canada and other central banks have had success with inflation targeting,” he said. In Canada, inflation has remained relatively stable and close to 2% for almost 30 years. And we’re determined to get it back on target with rate hikes and clear communications. »