MNI INTERVIEW:BOC Faces Sticky Inflation Fight-Research Winner

Canada needs "moderately" high interest rates while facing sticky inflation after seeing big price gains take root through the pandemic, while bloated housing costs threaten long-term productivity, an economist whose research has been backed by a central bank award told MNI.

The Bank of Canada, which has recently begun describing its policy stance as “restrictive”, needs tight policy after a slow response to the inflation run-up, University of Toronto professor Murat Celik said. Inflation has been stubborn compared with other economic cycles because of turbocharged stimulus including money sent directly to households, he said, without being more specific about the levels of interest rates he would recommend.

“If we never had that inflation go up as much as it did, maybe it would have been easier to keep things in check," Celik said. "But now that people's expectations regarding inflation are high, that has a self-fulfilling prophecy component that makes it harder to go back to 2%, 3% inflation.”

“We will have periods where we will have moderately high interest rates and moderately high inflation,” he said.

The comments come as investors swing between betting on Governor Tiff Macklem cutting rates amid a potential recession or raising them a ninth time to check inflation. The BOC on April 12 held the key rate at 4.5% for a second meeting, the highest since 2007, and policymakers said they could hike again or hold a restrictive rate for longer because of the risk inflation sticks above a 2% target.

LIMITS ON HIKING

“The United States and Canada and the European Union, all of these countries, were following this zero interest rate policy a little bit longer than we should have if they did not want to create inflation,” Celik said. “We have been used to low interest rates for two decades, but in the past that was not the norm.”

That sentiment echoes a recent speech by BIS chief and former Mexican central banker Agustin Carstens. He said policymakers in future may need to be less aggressive chasing economic growth with low rates than in past decades.

Canada's policy may diverge from the Fed’s due to differences in consumer finances such as mortgages, Celik said, though there are limits. Macklem in March said he would likely pause rates while the Fed and ECB said they were still hiking. He moved more in line with peers this month by dropping some language about pausing while keeping a phrase about a hike.

After hiking faster than the Fed last year including a 100bp move in July, the BOC's rate is now lower than the U.S. benchmark. Canada's inflation is lower, but its housing market is by some measures about the most overvalued in the world. The standard mortgage is also refinanced every five years unlike America's vanilla 30-year loans. Canada's bank regulator OSFI said Tuesday cracks in the housing market after interest rates jumped is the biggest risk, ahead of global liquidity concerns.

“If you raise interest rates and when people and companies are as indebted as they are, then you run into the risk of increasing defaults,” Celik said of central banks generally, then turning later to Canada. “Household debt and household mortgages are much more sensitive to interest-rate hikes, so that also limits what the Bank of Canada can do.”

COST OF LIVING

Over the longer term, housing inflation may become a drag on competitiveness by scaring away workers and investment, said Celik, who won this year's "Governor's Award" which provides two years of research funding. One idea he will investigate is whether investment is being sent to the most productive industries and if government intervention can be helpful.

Canadian productivity is burdened less than commonly thought by being a resource-dependent economy, he said. “There is of course this resource curse that’s been an idea for a long time in economics, but I think the Canadian economy compared to other countries is sufficiently diversified.”

The other area Celik will dig into is housing and competitiveness, which he says appears more troubling. Single-family homes in Toronto long ago blew past the one-million dollar mark and consumer debts are larger than the country's GDP.

“This is an issue for the private sector, even the University of Toronto” where high housing costs can deter people from accepting job offers, he said. “It’s making it harder to attract people” and “it’s making Canada less competitive.”