One cannot choose a combination of employment and inflation, as one mixes hot and cold water as one pleases in one’s shower. If the Bank of Canada wants to maximize employment in a sustainable way, it must first control inflation around 2%, its primary mission.
Posted yesterday at 11:00 a.m.
Even in the United States, where the Fed officially has the dual mandate of stabilizing prices and maximizing employment “in a sustainable manner”, in practice the employment objective is subordinated to the fight against inflation.
This is not a deception or an ideological choice, but an empirical observation: except in the short term, employment cannot be increased by low interest rates when inflation is high. This policy is inherently unstable, causing even more inflation, which ends in a severe recession and rising unemployment.
In ‘maximizing employment in a sustainable way’ the key word is ‘sustainable’, because low unemployment in an overheating economy is a ticking time bomb.
On the other hand, when inflation is under control, a central bank can promote employment in this moment of grace called “divine coincidence”, where the two variables are at best in an economy operating at maximum capacity, neither more nor less .
Yet the crude interest rate tool quickly runs out of steam, unable to train the workforce to fill available jobs or increase the number of skilled immigrants. It is therefore necessary to deploy a panoply of microeconomic policies to complement the macroeconomic policy of the central bank.
Inflation 101
Remember that inflation rises when demand for goods and services exceeds supply, or the economy’s production capacity, as it does now. Conversely, inflation decreases when demand is lower than supply.
By raising interest rates, central banks aim to moderate demand so that it equals supply. However, this soft landing is perilous when inflation is as strong as it is now. Rate increases immediately hit consumers and businesses, who borrow less to spend or invest, but take up to two years to deliver all of their inflation gains.
This lag makes it difficult to determine when the increases will be sufficient for inflation to return to 2% in 2024, as predicted in the recent Monetary Policy Report. Too much is to cause a severe recession; not enough is to lose credibility.
However, credibility plays a critical role, beyond the mechanical effects of rate hikes. A central bank that lets inflation run wild with insufficient rate hikes risks unanchoring precious expectations of a return to 2% and fueling a spiral out of control. Expectations about the future course of inflation condition the behavior of people and businesses and become self-fulfilling.
A more nuanced target
Last year, the federal government and the Bank jointly renewed for five years the inflation target of 2% — “the best contribution that monetary policy can make to the well-being of Canadians” — in effect for three decades. .
While emphasizing the preponderance of the target, they agreed to seek the achievement of a “maximum level of sustainable employment”, even if the Bank does not have all the tools for this task.
This new mention of employment in the Bank’s mandate does not change anything concrete, except for more transparency, because that was already what it tried to do when demand was too weak.
The government having co-signed the mandate, it must now respect the operational independence of the Bank, so that it can take the necessary decisions, however unpopular they may be. History teaches that politicians would not have that courage.
Defeating inflation is the challenge of the hour. It erodes the purchasing power of workers, which wage increases are struggling to compensate for, and hits low-income people the hardest.
In the scenario of a strong slowdown forecast by the Bank or that of a weak recession, unemployment will remain contained this time, as employers will be reluctant to lay off their skilled employees, knowing the shortage of structural labour.
Markets wait for the pivot
The financial markets, addicted to low interest rates, are coping very badly with global monetary tightening. They nervously scrutinize the words of the central bankers to guess the moment of a possible pivot, which will mark the beginning of a pause, then a relaxation, favorable to investments.
Yet, if they thought central banks were losing their fight against inflation, they would react negatively, writing risk premiums into bond yields, which would translate into higher mortgage rates.
Bank of Canada Governor Tiff Macklem says monetary policy tightening isn’t over, but is winding down, suggesting that future hikes will be less steep. Fed boss Jerome Powell didn’t go that far.
It must be said that the tea leaves are hard to read with the confluence of crises: the residual effects of COVID-19, the war in Ukraine and its shock on the price of energy, global warming and the decarbonization of the economy, tensions with China and the redeployment of supply chains, the rise of populism, not to mention the risks to the stability of the financial system posed by widespread indebtedness.
The inflation battle is not won.