Why it is so hard for the Bank of Canada to crush inflation

As prices soar and wages struggle to catch up, it may be hard to realize that just two years ago central banks were worried that inflation was not too high but dangerously low. Just as low inflation was embedded in the economy then, rising prices are now like a ship that cannot be easily turned.

Senior deputy governor warns 'expectation spiral' will mean more rate hikes

Crushing a car is easy but crushing inflation is hard. Persistent demand for vehicles, a worker shortage and overseas inflation mean the Bank of Canada is worried we will put today's inflation into our long-term planning. (Rebecca Cook/Reuters)

Those who think central bankers are powerful and manipulative might ask themselves why people like senior deputy governor Carolyn Rogers don't just snap their fingers and make inflation go away.

The Bank of Canada officials have declared they will be "resolute" in crushing inflation, squeezing it down to the bank's two per cent target range. But that process may be long and painful as rates keep rising.

Even as Rogers warned on Thursday that Canada faces an "expectations spiral," trying to change the direction of inflation is akin to turning the Titanic after you've spotted an iceberg through the fog.

Economy is too strong

Not that the Canadian economy is anywhere near sinking. Instead, the problem laid out by Rogers is one of an economy that is simply too strong.

"Demand continues to outstrip supply in many parts of the Canadian economy and short-term inflation expectations of Canadians remains high," said Rogers to Calgary Economic Development, a privately and publicly funded agency.

The solution, said Rogers, was to use a sharp rise in interest rates to crush demand, offering supply a chance to catch up.

As the European Central Bank also announced Thursday, the plan is to do what they call "front loading," several large hikes in interest rates in a row quickly to shock the market. It's an attempt to "avoid the need for even higher rates down the road and the more pronounced slowing of the economy that would go with it," said Rogers.

Bank of Canada senior deputy governor Carolyn Rogers said that while the bank does not have a target for interest rates, it does have one for inflation and that is the range between one and three per cent, a long way below its current rate. (Julie Gordon/Reuters)

Despite the risk the central bank could "overshoot," raising interest rates too high and sending the economy into a deep recession, the Bank of Canada insists there is still a chance the country could see a soft landing.

But for now, the problem is getting inflation down — and central banks around the world face many obstacles.

Fiscal spending such as European consumer energy subsidies or Canada's social assistance funding push in the opposite direction of where the central bank hopes to go. And rate hikes themselves can make things more expensive.

Global inflation could increase the cost of Canadian imports, although a rising loonie could act as a pad against those inflationary effects. And there is no guarantee there may not be more supply shocks ahead, including for energy, said Rogers.

Why the lag?

Another problem central banks always face is that the interest rate cuts or increases they make now may not work their way through the economy for years. Rogers said the same thing is likely to happen this time.

In that way, front loading could give central bankers a chance to read the indicators as they come in, such as GDP, job numbers and other data, and use smaller rate hikes once they see how the economy is reacting — helping to avoid an overshoot.

Consumer spending and wage demands are places where it is relatively easy to see how there is a lag time between rate rises and slower demand.

As others have mentioned in the past, a buildup of savings by those who could afford to save during the pandemic means retail spending will not necessarily respond immediately to higher interest rates. Rogers said the central bank continues to monitor those savings, and they are far from exhausted.

WATCH | The central bank's plan to rein in inflation: 

Bank of Canada hikes interest rates to 3.25%

2 years ago
Duration 2:00

House prices are already being driven down by rate hikes that make it harder to take on mortgages at levels seen just a year ago, she said. But those higher rates are only gradually cutting into people's budgets. Rate hikes only become obvious to most mortgage holders when they renew, maybe not for years. The cost of consumer loans such as cars only become part of the budget when people decide to buy a new vehicle, which is infrequent.

Rogers said that so far the expectations spiral she described has been driven at least partly by the labour shortage. On Friday, economists expect the latest employment numbers to show that the economy has continued to create new jobs.  

The central bank, and others, will be watching the wage increases in the Statistics Canada data that last month showed wages rising at a rate of 5.2 per cent, well above the Bank of Canada's inflation target.


Short-term expectations versus entrenchment

"We are in an environment of extremely tight labour markets, excess demand and high inflation," Rogers said in answer to a reporter's question. "We know employers are very focused on attracting and retaining employees."

Despite that, she said it is not the job of the central bank to set wages or prices.

"We understand also that workers are, you know, they're looking at the rate of inflation and what it's doing to their purchasing power and they're thinking, 'I need a raise.'"

Members of the British Columbia General Employees' Union (BCGEU) picket outside a B.C. Liquor Distribution Branch facility in Delta, B.C., on Aug. 15. They deal they've struck could be a model for others. (Darryl Dyck/The Canadian Press)

But by hiking interest rates, she said, the bank hopes to prevent short-term inflation expectations — which we are already seeing — from turning into entrenched expectations, which she defined differently:

"The scenario that we are worried about is that Canadians look at the current rate of inflation. They think it's here to stay. They start incorporating that thinking into their long-term decision making."

Just this week British Columbia civil servants fought out a wage increase that, while it was below current inflation, was well above the central bank's target. Negotiated after a strike vote of 95 per cent, the deal is seen as a model for other workers across Canada where wages have been falling far behind inflation.

5.5% wage hike in year 2

Although it has not yet been ratified by union members, the settlement offers an increase of 3.25 per cent retroactive to April this year. But next spring, when the bank hopes to see prices and wages start to decline, the workers will get a minimum of a 5.5 per cent pay hike — and more if inflation remains high.

The deal offers a second example for a lag after the central bank begins to hike rates. As other contracts and negotiations come due, each group in turn will feel they have to catch up with other wage increases. That too could unfold over a period of years.

On the bright side for Rogers and the central bank's hopes to bring inflation back down, the B.C. employees deal offers workers a maximum of three per cent in its final year of 2024-2025, which is within the Bank of Canada's inflation target range.

But for borrowers worried about how high Canadian interest rates will go, Rogers said she's not telling, because she is not sure either — just that they will go as high as they have to.

"You know, we don't have a target for interest rates," said Rogers. "We have a target for inflation."

Follow Don on Twitter @don_pittis


Don Pittis

Business columnist

Based in Toronto, Don Pittis is a business columnist and senior producer for CBC News. Previously, he was a forest firefighter, and a ranger in Canada's High Arctic islands. After moving into journalism, he was principal business reporter for Radio Television Hong Kong before the handover to China. He has produced and reported for the CBC in Saskatchewan and Toronto and the BBC in London.