MNI INTERVIEW: Tight BOC Policy Beats Coordination- Researcher

Aggressive interest rate hikes are a more effective way to fight inflation than policy communications about future actions like coordination with fiscal policy, and the Bank of Canada's moves so far seem to be paying off, an academic who has studied price expectations alongside BOC staff told MNI.

Canadians appear to base economic decisions on recent trends instead of forming detailed expectations about the future, according to Simon Fraser University professor Luba Petersen, a finding based on experiments asking students to evaluate different economic and policy scenarios.

That behavior differs from some common economic models predicting consumers are “rational” about the future and incorporate the impact of policy changes likely to change the economy’s trajectory.

“It’s really on the central bank and the policymakers to maintain credibility by aggressively responding to inflation, in the scenario that we’re studying here in the lab,” she said in an interview. “We found the best way to tame those expectations is to tame inflation itself, and that’s where the central bank really needs to do whatever it takes.”

The Bank may be taking this lesson to heart, hiking rates a full percentage point in July in the biggest such move since 1998 as it moved from near zero to 4.25% this year. Governor Tiff Macklem says outsized increases will help ensure perceptions of high inflation don’t become entrenched. Even while signaling a pause last week after seven straight hikes, officials say they can keep being forceful if needed.

THE CONFLICT CASE

The lesson from Petersen's research is also timely when looking at the response to the pandemic, when Canada’s finance minister, BOC Governor and top banking regulator touted the power of coordinated economic supports. Macklem also pledged to hold interest rates near zero in the depths of the recession.

More recently, fiscal and monetary policy have clashed more, with big rate hikes and governments spending some of the windfall from the economic rebound on more relief checks for households funded by deficits. (See: MNI INTERVIEW: Canada Still Lacking Fiscal Restraint-Ex Deputy)

The danger of economic instability from that policy disconnect is less important in a world where Canadians don't look that far ahead, Petersen suggested. Central banks fearful that today's deficits will be tomorrow's inflation may also be motivated to act more forcefully to keep things under control.

"That conflict case had an even more aggressive central bank who was trying to offset what the federal government was doing. And that extra aggressiveness is what really helped to keep inflation managed, and that in turns helps to keep expectations better managed too,” she said.

THE RIGHT DIRECTION

With inflation slowing from a four-decade high of 8.1% in June to 6.9% in October, there is a path to pull inflation expectations back down toward 2% as well.

“The Bank of Canada has the tools that it needs, and it seems to be adjusting rates in the right direction,” she said. “If anything what we are seeing right now is inflation is starting to come back down, so it seems that we’re on the right track.”

But it could take some time, she suggested. “You can see it in the data now. Inflation expectations are still high, even though interest rates have been going up, and so what people seem to be responding to is recent inflation experiences, not expectations of future monetary policy and the future state of the economy.”

Some of the findings could influence future decisions about the choice of inflation target in Canada and even the U.S., with the BOC looking in the past at a price-level target and the Fed a few years ago seeking to average inflation over time.

Households that aren't forward-looking mean that adopting a price-level target would be unhelpful, Petersen suggested. When Canadians look at the here-and-now rather than make detailed future forecasts, seeking to boost prices after a period of sluggishness could lead people to over-react, she said.

Source: Bank of Canada