Central bank "using a very blunt instrument to attempt to bring prices down"
The risk of the Bank of Canada triggering a recession through interest rate hikes is “high,” according to a prominent economist who says the central bank’s policies could be missing their intended mark.
David Macdonald (pictured top), senior economist at the Canadian Centre for Policy Alternatives, told Canadian Mortgage Professional that price growth across multiple categories could remain elevated despite the Bank’s aggressive stance on its benchmark rate – because rate increases have little to no impact on those measures.
“One of the big problems in attempting to control inflation with interest rates is that some of the big drivers of inflation having nothing to do with what’s happening in Canada, and so the interest rates are going to have little effect on them,” he said.
“The rising price of gas in particular, which is determined largely by international markets, [and] the rising price of food are not going to be brought down just because interest rates are higher in Canada.”
Some parts of the inflation index are rate sensitive and will be affected by the Bank of Canada’s decisions on its benchmark rate – namely residential real estate, with the country’s housing market having seen prices fall and interest cool since the central bank embarked on its rising-rate trajectory.
Still, others are impervious to rate hikes – and that could have significant consequences for the Canadian economy, according to Macdonald.
“The real challenge the Bank has is they’re using a very blunt instrument to attempt to bring prices down in areas that are not interest rate sensitive,” he said. “What that may mean is that we don’t end up with a soft landing, but with a recession.”
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That’s not to say the Bank has a variety of tools at its disposal to tackle inflation in Canada, which recently hit 7.7% – its highest level for nearly four decades. The central bank is largely a “one-trick pony” when it comes to that issue, Macdonald said, with its major instrument being the overnight rate.
The federal government, by contrast, has several ways of impacting the inflation index – notably in the housing market, where regulatory changes could pour further cold water on some of the skyrocketing price growth seen in recent years.
“It’s certainly within the federal government’s power to change regulations that would affect house prices, particularly mortgage underwriting rules or the rules to get mortgage insurance,” Macdonald said.
That could mean measures aimed at subsections that have been significant drivers of home price appreciation – for instance, targeting investors with stipulations that they be required to put down 50% rather than 20% to qualify for mortgage insurance.
The Bank of Canada slashed its benchmark lending rate to a rock-bottom 0.25% at the onset of the COVID-19 pandemic in March 2020, keeping that trendsetting rate resolutely low over a stretch of nearly two years.
Inflation has surged in 2022 to date, belying the central bank’s earlier confidence that it was a “transitory” phenomenon and heralding a flurry of rate hikes: the first of a quarter point, followed by 0.5% increases in its two most recent policy rate announcements.
Another so-called oversized rate hike appears inevitable in the Bank’s next announcement, scheduled for mid-July, with Dominion Lending Centres (DLC) chief economist Dr. Sherry Cooper noting that persistent levels of inflation meant the central bank will “undoubtedly” introduce a three-quarter-point increase then.
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That would mirror the last rate decision by the US Federal Reserve, which hiked its own benchmark rate by 0.75% in mid-July in a bid to curb inflation.
Despite the mounting inflation crisis, Canada’s economy appears to be purring along, with unemployment recently hitting its lowest level (5.1%) since comparable data became available in 1976. The Bank of Canada projected “solid” growth in 2022’s second quarter and noted the economy’s resilience in its last rate announcement in early June.
That means the only prospect of a significant economic downturn is if the Bank of Canada raises interest rates too quickly, according to Macdonald.
“There are some segments of the CPI [consumer price index] that will absolutely come out with higher interest rates. But the other parts - it’s going to be hard to bring them down without a recession. I think that’s the real danger we’re in,” he said.
“We’re not in a recession. In fact, the economy is going relatively well and the unemployment rate’s very low. We’re not going to be in a recession – except if the Bank causes one by increasing interest rates too quickly.”
