The Bank of Canada’s impossible job in battling inflation

Year-over-year, inflation has been on the rise since June 2020, and above the two per cent target since January 2021. Last month, it reached its highest level of the last 40 years — 8.1 per cent. Still, many experts fear that it may have not peaked yet.

And Bank of Canada Gov. Tiff Macklem seems to agree. He conceded that “we may see a few more months with inflation around eight per cent” before declining to 7.2 per cent in December, and — sounding optimistic — to three per cent by the end of 2023. He also admitted that it could take until the end of 2024 for inflation to return to the two per cent target.

Consequently, if inflation is expected to remain high until the end of the year, more interest rate hikes must definitely be on the way. Indeed, the consensus among economists is that the Bank of Canada will raise the policy rate by 75 basis points in September, thus bringing it to 3.25 per cent — its highest level since April 2008, and above the so-called “natural” or “neutral” rate that neither stimulates nor holds back the economy.

But as long as inflation does not abate, it seems safe to expect that the Bank of Canada will continue raising its target for the overnight rate in the hope of saving its credibility — even if to no avail. Therefore, nobody should be surprised if the benchmark rate is raised to around 4.5 per cent by the end of the year — a rate not seen since before the Great Recession.

To be fair, the Bank of Canada’s likely lack of success in fighting inflation is not totally its fault since the only tool it has is the rate of interest. Hence, if inflation does not subside, the only thing the bank can do is to increase the interest rate even more. That is, if the medication is not working, double the dose, says the doctor — until the medication, and not the disease, kills the patient.

We must understand that today’s inflation is not driven by excess demand. Therefore, today’s inflation is not a job for the Bank of Canada — it’s a job for the government. But the government seems reluctant to take responsibility and deal with the domestic source of today’s inflation — more precisely, with corporate greed. Rather, the government prefers to hide and save face, while throwing the Bank of Canada under the bus.

In any case, while tight monetary policy might be ineffective in curbing today’s inflation, it will achieve an objective even more important to those the government might be ultimately representing. As I argued in a previous article, the underlying objective of interest rate hikes is to increase unemployment to prevent workers from demanding a wage hike similar to the price-increase that already took place. That is, the bank tries to cut short a wage-price spiral, which Macklem suggests is prompted by workers’ wage demands. “Employers can’t find enough workers and they’re increasing wages to attract and retain staff,” he said. “With households spending robustly, businesses are passing on higher input and labour costs by raising prices.”

Well, Macklem should know better than to blame workers for the rise in inflation. Workers are not demanding higher wages to increase their share in the value created with their labour. Rather, they are demanding higher wages to restore their purchasing power to the level they had before the increase in prices — a price-increase for which they are not responsible.

Indeed, while year-over-year inflation was 8.1 per cent in June, average wages increased by only 5.2 per cent. And in 2021, annual inflation was 4.8 per cent while average wages rose by only 2.1 per cent. So, definitely, wages are not fuelling inflation.

Rather, it is the owners of capital who are responsible for the initial price-increase. Indeed, they raised prices to increase the share of profits in the value created by their workers’ labour. And it is this initial price-increase that reduced the purchasing power of wages, which workers are now trying to reverse through wage-increases. And to achieve this goal, workers need the bargaining power provided by a tight labour market and low unemployment.

And here is where the Bank of Canada comes into action: it increases interest rates to reduce demand, cause a recession, and increase unemployment to weaken workers’ bargaining position. But a 4.5 per cent policy rate will not be sufficient to cause a recession deep enough to prevent workers from demanding wage-increases. Therefore, it seems safe to expect the Bank of Canada to continue raising the policy rate at least until the second quarter of 2023.

A historical example may help to illustrate this point. In the first quarter of 1990, the inflation rate was lower than today’s and the unemployment rate higher — inflation was 5.3 per cent and the unemployment rate was 7.3 per cent. Concerned with the existence of inflation more than with its level, the Bank of Canada increased the policy rate to 14 per cent and kept it above eight per cent until the end of 1992 — thus causing a very deep recession with the unemployment rate rising to 12 per cent by November 1992. With such economic and social cost, the Bank succeeded to bring inflation down to 1.6 per cent by January 1992.

But this drop in inflation of the early 1990s required a jump in the real rate of interest to more than eight per cent — that is, it needed a positive difference of more than eight percentage points between the nominal rate of interest and the rate of inflation. With a nominal interest of 4.5 per cent and inflation at 8.1 per cent, the real rate of interest would be still quite negative. So, how much higher the policy rate needs to rise to cause a deep enough recession and lessen workers demand? Well, hard to say — and a straightforward extrapolation from the early 1990s does not seem a sound approach. However, since even a broken clock is right twice a day, I would dare to guess to somewhere between six and eight per cent — or until the rate of unemployment rises to around seven per cent or so.

To summarize, let me reiterate that today’s inflation is not a job for the Bank of Canada. Defeating inflation by lowering real wages, while allowing corporate profits to rise, is not the right approach. Workers deserve better from our government. Rather, the government should implement policies that address the domestic sources of today’s inflation, which are neither excess demand nor undue wage increases.

Gustavo Indart is a professor emeritus in the economics department at University of Toronto.

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