Following closely on the heels of the European Central Bank and the U.S. Federal Reserve Board, the Bank of Canada has raised its target interest rate by 50 basis points. This is its sixth interest rate hike this year.
Central banks around the world have been trying to tame inflation, which has been running hot — at close to a double-digit rate — in the past year. Canada’s inflation hit a three-decade high in March 2022.
While reactions about the interest rate increase have been mixed, as an economist, I argue that the timing of the central bank interest hikes have been appropriate. These hikes are the only option the central bank has to counter rising inflation.
Keeping inflation under control
There are a few reasons why inflation needs to be kept under control by central banks. For one, not all workers’ wages increase proportionately with price increases. In Canada, news reports suggest that 25 per cent of the population have not been able to afford food and utilities, and in many cases have been forced to increase their debt.
Worldwide, the United Nations estimated that the number of people affected by hunger in 2021 had risen by about 46 million since the year before, and 150 million since the outbreak of the COVID-19 pandemic.
Another reason to control inflation is that, for many retirees, pension increments do not fully adjust for inflation. This means that many people’s pensions are not keeping up with inflation, which affects their standard of living.
Rising interest rates typically lead to lower economic growth, as well as lower stock market valuations, meaning people that own stocks are hit hard during interest rate hikes. Because of this, central banks must balance the costs of food affordability for lower income households with declines in the wealth of higher income households.
Central banks are compelled to control inflation since it can quickly spiral out of control without their intervention. Feeding on itself, there is a risk of the formation of an inflationary wage-price spiral. This occurs when workers negotiate greater wage increases, which puts more cash into their hands and leads to more inflation, which in turn leads to greater wage increases, and so on.
Global inflation on the rise
The current inflationary climate began during the worst of the COVID-19 pandemic in 2020. The second quarter of 2020 witnessed a dramatic drop in the Gross Domestic Product of most countries. Canada’s GDP fell by 11 per cent in April 2020, the deepest plunge since the Great Depression. As lockdown-hit businesses suspended regular activity, many workers lost their jobs and the unemployment rate hit double digits. In addition, global supply chains broke down, leading to widespread shortages.
Governments in most countries responded with multiple policy tools. Most countries responded with dual policy relief — monetary and fiscal — to alleviate the situation. Central banks cut short-term rates, and increased the purchase of government and corporate bonds to lower long-term rates.
At the same time, governments cut taxes and sent cash payments to lower- and middle-income households. While some of the people who received these payments spent the handouts on food and essential items, many others purchased more expensive items, such as computers and electronics, and others just increased their cash balances.
This increase in cash balances for a large proportion of the population was one factor that set up the start of the inflationary climate. During this same period, supply chain shortages also led to inflationary pressures.
By mid-2021, inflation had reached three to five per cent in Canada, the European Union and the U.S. Meanwhile, labour markets recovered rapidly and wage growth picked up, especially for workers willing to change jobs.
Appropriately timed rate increases
The major central banks decided to delay rate increases early in the pandemic, citing some of the inflationary pressures as temporary. But as inflationary pressures continued to increase into 2022, central banks were criticized widely by economists and influential investors.
The Bank of Canada raised its interest rate to 0.50 per cent in March 2022 — its first interest rate increase since October 2018. Since then, it has been making up for lost time by increasing its rate by a cumulative 3.5 per cent with a sequence of jumbo 0.75 per cent hikes, while the Federal Reserve Board has so far raised them by 3.25 per cent.
Critics have interpreted these jumbo hikes to mean the central banks have admitted to their slow response to fight inflation in 2021.
In mid-2021, there was considerable uncertainty about how the COVID-19 pandemic would evolve. Vaccines had been developed very rapidly, but no long-term effectiveness data was available yet. In addition, the appearance of a series of new variants added greater uncertainty on whether the vaccines would stop the disease.
While the vaccines have been hugely successful in hindsight, there was widespread disagreement about how to handle COVID-19 early on. The central banks surely would have been blamed for raising rates in the midst of an economic recovery in 2021 if the pandemic had taken a turn for the worse, and the world economies had fallen back into hard times.
A valid criticism of the central banks is that they failed to account for the inflationary pressures created by fiscal policy, like tax cuts and cash handouts. Arguably, the actions taken by the central banks might have been strong enough to stimulate the economy without the fiscal policy actions taken by governments.
Going forward, there will be much debate about whether the central banks have moved too much, as recent data shows that inflation has slowed since the summer. Moreover, many forecasters now predict a recession in 2023, which might lead the central banks to reverse the rate increases. Nonetheless, they will be compelled to maintain higher rates, even if inflation slows to the five per cent range.
Uncertainty about future inflation remains high as some of the factors, such as COVID-related lockdowns, seem to be easing, while others, such as disruptions in food supply from the Russian invasion of Ukraine, may still cause some inflationary pressures in food and energy.
Most of the world has faced deflationary pressure since 2000. The forces of deflation, like low birth rates and high savings, will once again come to the forefront once the current problems are resolved.