MNI INTERVIEW: BOC Has Done Enough To Slow Inflation-CD Howe

The Bank of Canada's interest-rate pause is justified by measures of the money supply and Taylor rule models that could have helped policymakers avoid belated hikes after Covid lockdowns ended, according to an upcoming paper from the C.D. Howe Institute by former central bank researchers.

Those kind of indicators suggest the Bank's eight consecutive rate hikes through January have done enough to ensure inflation is coming back to normal according to Jeremy Kronick, the institute's director of monetary and financial research.

“If the Bank leaves the overnight rate where it is, subject to other shocks that can always happen, inflation is going to make its way back down,” Kronick said in an interview Monday.

Some investors have bet on a cut in the second half of 2023 as the economy moves towards recession, which Kronick called premature. “The Bank has to keep the overnight rate where it is for inflation to keep falling. If they keep cutting now down to the neutral rate, you lose the kind of tightness that you need,” he said. “It’s a forward-looking process and so the Bank is going to have to cut before (inflation) gets down to 2%.”

(See MNI INTERVIEW:BOC Seen Holding All Yr, Cut Is Long Shot-Gignac)

EVEN FIRST NOT ENOUGH

The models in the paper suggest there would have to be more evidence of an inflation slowdown to warrant a rate cut. So far, the gap between the policy interest rate and the paper's models have peaked and narrowed to about where they were before Covid, suggesting further hikes aren't warranted either, Kronick said.

Kronick and former BOC adviser Steve Ambler found that interest rates could have started rising by early- to mid-2021, rather than in March 2022, when Governor Tiff Macklem first lifted the record low 0.25% overnight rate. Their tracking of the money supply and the median estimate of several versions of the Taylor rule were already showing signs inflation was going to surge.

Even regular inflation showed a problem, the paper showed, quickening from 1.1% in February 2021 to 3.7% five months later. "This reinforces the idea that the Bank of Canada, like most central banks, fell behind the curve in fighting inflation," they wrote in the paper. Macklem also kept his conditional commitment to hold interest rates near zero until January 2022, a policy that burned some borrowers who took out variable rate mortgages only to see rates climb 425bps over about the last year.

Kronick said the Bank's actions also had to account for waves of Covid and how long governments might have kept shutting down parts of the economy. Canada was also the first major central bank to begin hiking and the first to pause, putting it in a better position today, Kronick said.

THE MONEY OVERHANG

Canada can still improve future actions by relying less on 12-month rates of the consumer price index that embed more backward-looking information, especially during big turning points in the economy, Kronick said. The BOC has in recent months given more attention to annualized three-month rates of inflation, something more like how Canada tracks quarterly GDP.

At a more basic level, the economy re-opened from lockdowns with consumers having saved up cash from government stimulus checks and the inability to buy many regular goods and services. That "money overhang" including the imbalance between the money supply and the inflation rate was a formula for demand to outgun supply, the paper said.

While the Bank may have felt confident putting little emphasis on the money supply in the past when inflation was reliably at or near the Bank's 2% target, there's evidence that when price gains accelerate it's a more useful and timely measure, Kronick said.