CIBC economists Avery Shenfeld and Andrew Grantham have been considering the alternatives to current Bank of Canada policy
This decade has been one of unpleasant surprises so far – pandemic, war in Europe, global inflationary pressures – and some of the old ways of dealing with these problems have been upended.
Just as health and warfare have required alternative ways of thinking in recent years, monetary policy may also demand a change from the standard way to fight inflation, as interest rates will only go so far before doing significant damage to the economy.
The Bank of Canada’s surprise rate hike this month is expected to be followed another in July, while the markets anticipate the Fed will hold steady for now. But what next for the BoC if rate rises don’t curb stubborn inflation?
Avery Shenfeld and Andrew Grantham from CIBC Economics have been considering the options in an article called Rethinking Canadian Fiscal Policy.
They start by establishing that the only way to address high rates of inflation is by weakening demand – that’s what interest rates are meant to do, but it does rely on Canadian consumers and businesses responding by cutting back enough to bring price increases down. Tightening the fiscal belt is another level the BoC could pull.
Currently, CPI inflation was 5.1% year-over-year for the first quarter of 2023 and is expected to fall to 3.4% in Q2, 2.9% in Q4, and not the BoC’s 2% target until the second quarter of 2024. However, the full year 2024 would still be slightly elevated at 2.1%.
Real GDP growth is also elevated with Statistics Canada reporting a 3.1% annual growth rate in the first quarter of 2023, although this is projected to ease in the remainder of the year.
On the plus side, the economists see inflation return to the central bank’s 2% target in 2024, but without additional policy intervention this will likely mean we are facing elevated interest rates for a longer period before the BoC can start to bring them down again.
CIBC’s current projection is that rates will reach 5% by the fall and remain there until June 2024 with a cut to 4.5%. However, by the end of 2024 the overnight rate will still be elevated at 3.5%.
The duo suggests that governments at all levels should be looking at keeping a lid on spending and not be tempted to make tax cuts in their statements this fall. They could also ease back on the public labour force, which has been growing at a stronger pace than the private sector, adding to upward pressure on wage inflation.
Fiscal restraint
The economists also give a stark reminder that “one way or another we will need to go through at least a stall in growth to get inflation back to the 2% target,” and call for fiscal restraint from policymakers.
While this would have a negative impact on growth, it would also allow interest rate hikes to ease while still tackling inflation, while also helping to address the public debt burden which has risen due to the pandemic and the following years.
Interest rates, if they continue to rise or even remain high, have several negative effects on parts of the Canadian economy.
These include weakening construction of homes when supply is the single-biggest issue cited by industry experts consistently, weakening business investment which is important to tackle labour shortages and boost productivity, and creating a risk to household financial stability as mortgage rates become increasingly challenging to budgets.
The full report is in the research section at https://economics.cibccm.com/
