February 22, 2024
The surge of inflation over the past three years has been a “stark reminder” that central banks can’t always ignore supply shocks and hope price increases stabilize on their own, Bank of Canada Governor Tiff Macklem wrote in an essay published last week as part of a broader soul-searching effort by some of the world’s top central bankers.
In comments that are among his most detailed to date about the bank’s fight with inflation, Mr. Macklem wrote that he and his team had underestimated the inflationary risk posed by the combination of supply shocks and elevated consumer demand during the COVID-19 pandemic. The bank’s models weren’t properly calibrated to measure price pressures throughout the economy, he wrote, and bank officials were “not sufficiently attentive to the risk that inflation could rise sharply.”
The essay appears in an online book published by the Centre for Economic Policy Research, which brings together writing from leading central bankers and economists, including European Central Bank board member Philip Lane, Federal Reserve board member Chris Waller and former Fed chairman Ben Bernanke.
As inflation around the world has retreated – it has fallen to 2.9 per cent in Canada from a peak of 8.1 per cent, for example – policy makers have begun to reflect on what caused the most significant inflationary surge since the 1970s and why central bankers were slow to respond.
They have also begun thinking about how to improve monetary policy making going forward, while wrestling with the after-effects of the most rapid and co-ordinated interest-rate hiking campaign in a generation.
“While the central bank response to the post-pandemic period of high inflation seems to have been successful thus far, the aggressive pivot and then tightening of monetary policy over 2021-2023 generated new risks,” economists Bill English, Kristin Forbes and Ángel Ubide wrote in the introduction to the book.
“The unexpected and aggressive hikes in interest rates have caused financial stress for households, businesses, and financial institutions; bankruptcies are picking up quickly and housing transactions have largely frozen in many countries. The fiscal positions of many countries have worsened and could require substantial reductions in spending and increases in taxes – neither of which will be politically popular.”
Mr. Macklem’s essay focuses on the Bank of Canada’s forecasting errors and why it waited until early 2022 to start raising interest rates despite fast-rising inflation – something he and his colleagues now see, in retrospect, as a mistake.
Historically, central banks have tended to play down supply shocks – such as jumps in oil prices or transportation costs – when setting monetary policy, given that interest rates influence demand in the economy, not the supply of goods and services.
When consumer goods prices jumped in 2021 as a result of a rebound in oil prices, as well as supply chain disruptions and a surge in demand for goods that could be used during pandemic lockdowns, Mr. Macklem and many other central bankers dismissed this as “transitory.”
That proved to be a serious miscalculation. The supply shocks percolated through the economy, mixing with overheated demand that was fuelled by government support cheques, ultra-low interest rates and a shift in consumer spending patterns.
“With businesses having trouble keeping up with demand, they were less worried about losing customers if they raised their prices. Other firms, now facing higher prices for intermediate inputs, would in turn raise their prices, creating a ripple inflationary effect through the supply chain to broadly higher final goods prices,” Mr. Macklem wrote.
“And consumers, eager to finally buy what they couldn’t get through the pandemic, paid the higher prices. As a result, the impact on inflation of the price shocks was faster and more widespread than our models suggested.”
Mr. Macklem wrote that the bank has learned a number of lessons over the past three years. For one, it’s dangerous to discount supply shocks – a crucial point for the bank to take on board in a world that could increasingly be defined by trade conflicts and climate-related disruptions.
He added that bank economists also need to get better at looking under the hood of the economy, and seeing where specific price pressures are coming from, both domestically and internationally. Economic models that focus on aggregate supply and demand numbers can sometimes miss crucial things.
And the bank needs to get better at communicating with the public, he wrote. “The prolonged period over which inflation has been above the 2 per cent target may have undermined the trust that Canadians have in their central bank. While this poses a challenge, it also presents an opportunity. By providing more insights into our monetary policy decisions, we can help citizens understand what we are doing and why.”
