By Ketki Saxena
Investing.com -- In a year-end interview with The Globe and Mail, the Bank of Canada governor acknowledged “a very big forecast error” from the Canadian central bank in 2022.
2022 was a year that started with the Bank of Canada adamant that mounting inflation was “transitory”, and would be close to 2% by the end of 2022 - reasoning that caused the Canadian central bank to hold rates at their extreme lower bound level of 025% until March, even as inflationary indicators mounted, and a chorus of private sector economists en masse called for higher interest rates.
As we all know, inflation did not prove to be transitory. As inflation soared past 5%, the Bank of Canada’s rhetoric changed from inflation being “transitory” to inflation being “transitory but not short-lived”. The Bank’s policy stance also changed dramatically, and the Bank responded with bigger and bigger rate hikes to tame inflation that was now proving stubbornly sticky.
By the time CPI was headed towards its 8.1% peak in June, Mr. Macklem had backed away from his use of the word “transitory”, with the Bank of Canada acknowledging that inflation in fact appeared to be becoming entrenched.
The Canadian economy and labour markets too, had remained overheated, and far more robust than expected. A historically tight labour market had added another 220,000 jobs in the first half of the year, while GDP expanded at 3.3% at an annualized pace. GDP expansion came in ahead of the growth in the Canadian economy’s productive capacity, meaning the economy remained in excess demand.
In July, the BoC reacted with a supersized 100 bps move - the largest move in over two decades. All in all, after seven rate hikes the Bank ends the year with a policy rate of 4.25 per cent, a 15-year high.
In this period, the Canadian central bank has faced mounting criticism - first for failing to respond aggressively or quickly enough on inflation, and then for moving too aggressively and tightening too quickly, as the impact of the rate hikes begins to trickle through the Canadian economy. The Bank’s rate hike spree has caused a slowdown in the Canadian economy, sending housing prices tumbling, debt payments rising, and a slowdown in the labour market - all while Canadians still contend with high inflation, the combination of which has sharply reduced spending power.
“So, yes, we have some explaining to do”, the BoC governor acknowledged.
“Canadians are being harmed by inflation, they’re feeling the pain. They’re also feeling the strain of rapid increases in interest rates. They’re asking a lot of tough questions; their elected representatives are asking a lot of tough questions. I understand that,” he said. “They should be asking tough questions. They should expect a lot from their central bank.”
And so Mr. Macklem attempts to respond to some of these tough questions: how did the Bank of Canada so badly underestimate inflation, and is it on the right track moving forward?
When it comes to how the BoC miscalculated inflation, the governor offers three factors: unprecedented supply disruptions related both to Covid-19 and the war in Ukraine; the robust economic reopening after the Omicron-wave proved to be the last major Covid-19 mass scare; and perhaps most importantly, a miscalculation of the CPI- common metric.
Typically the bank’s preferred metric to measure inflation, the CPI-common was proved wildly unreliable over the past two years. At the start of 2022, the CPI-common reading hovered around 2% even as headline consumer inflation soared. However, Statistics Canada has now revised CPI-common readings upward multiple times, and believes the reading was actually twice the Bank’s target level in January - and flashing signs of overheating as early as July 2021.
The BoC governor also provided something of a Mea Culpa:
“If we’d known that there wasn’t going to be another wave, and that the economy would reopen rapidly, and that households would come very rapidly back into the market and try to catch up and buy so many of the services that they hadn’t been able to enjoy for the last couple of years – yes, I think if we could have foreseen that, we would have started to raise interest rates earlier,” Mr. Macklem said.
In terms of going forward however, Mr. Macklem believes that the Bank of Canada is now on the right path.
“We’ve acted forcefully; it’s started to work. Once the snow melts, once spring comes, I do think you’re going to see core inflation start to really come down in a more meaningful way”.
He also doubled down on his statement that over-tightening is a greater risk than under-tightening policy, even as the Canadian economy heads into a recession next year.
As to whether he and Bank policymakers made an error in judgement, Mr. Macklem says that is an answer “The course of history will have to decide. We’re not through this yet.”