Best: Why the Bank of Canada should go slow in raising interest rates

Yes, there is enormous uncertainty about the future trajectory of inflation. The global economy has never been through a COVID pandemic before. But that uncertainty does not justify a return to knee-jerk anti-inflation arguments.

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In its latest interest rate announcement, the Bank of Canada signaled that it is likely to raise interest rates sooner rather than later – possibly as early as next spring.

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While the bank still calls inflationary pressures “temporary”, it is beginning to show signs of giving in to rising pressure from Bay Street, business experts and conservative think tanks to toughen inflation. This would be a serious mistake.

Yes, there is enormous uncertainty about the future trajectory of inflation. The global economy has never been through a COVID pandemic before, and we do not yet know exactly what the long-term effects of the shutdowns and the persistent bottlenecks will be.

But that uncertainty does not justify a return to knee-jerk anti-inflation arguments. If anything, we need to be more careful about drawing conclusions in times like these and pay close attention to the data.

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When we do, we find three unsupported myths driving the current calls to toughen inflation.

Myth # 1: We know inflation when we see it.

When we hear that inflation has not been that high for 18 years, it sounds as if we are in serious trouble. But are we? As Adam Tooze has explained in a recent Chartbook, inflation is incredibly difficult to measure. And it is particularly difficult to measure inflation right now: not only are current figures distorted by the very low inflation levels a year ago, but inflation levels are also unusually dispersed – so relatively high inflation in some sectors (cars, food and gas) is combined with low levels in others (most services).

Raising interest rates, a strategy that is good at tackling widespread price increases, is likely to be catastrophic when used against a very uneven form of inflation.

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Myth # 2: If the Bank of Canada does not do something soon, we will end up reliving the “big inflation” of the 1970s.

I have researched and written about the inflationary problems of the 1970s (and the failure of the monetary response in the 1980s). This is not a repeat of the 1970s. Trade unions – and workers more generally – are far weaker, and wages rarely have increases in the cost of living built in, so they cannot drive wage spirals. Central banks are also far more independent of their governments than they were then, and are ready to raise interest rates if necessary.

If we are to look for a precedent for today’s inflation, we should go back to the 1950s, when the run-up to the Korean War created bottlenecks that led to temporary inflationary pressures not unlike those we see today, as several economists have argued.

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Myth # 3: Higher inflation is much more risky than very low inflation.

Economists and some central bankers once thought that the best inflation target should be zero, as this meant that prices would be really stable. That idea has been rejected when it became clear that it left very little room for the central banks to maneuver in the event of a downturn, as zero inflation could quickly turn into deflation.

Deflation is much more frightening than moderate inflation because it is easy to get stuck in a deflationary spiral and very difficult to get out of – as we learned the hard way during the Great Depression.

The magic number for inflation targeting has instead become two percent. Yet even two percent could be too low if global growth slows. Although it has been easy to ignore in Canada, most of the rest of the Western world has been stuck in the country with “low inflation” since the 2008 crisis – in a desperate attempt to get inflation going again to avoid the dangers of deflation . As the Federal Reserve, the European Central Bank and the Bank of Canada have conducted major mandate revisions in recent years, everyone has focused on this changing global context as a key issue.

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Just a few years ago, economists and central bankers argued that we should consider raising the target from two to three or four percent to give monetary policy a greater chance of fighting when things go awry. Why is an inflation rate of 4.4 percent so frightening?

What Bay Street bankers, experts and conservative economists are not telling you is that if central banks raise interest rates too quickly, they could stall or even reverse the economic recovery.

Let’s hope the Bank of Canada sticks to its cautious, evidence-based approach and does not let inflationary fears get their way. We will all lose out if the Bank of Canada tightens its policy too soon.

Jacqueline Best is a professor at the School of Political Studies at the University of Ottawa.

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