Tackling Inflation Without Killing Growth

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Avery Shenfeld

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Avery Shenfeld, chief economist at CIBC.

Fortunately, some of our troubles with inflation will melt away on their own. They are tied up in the fact that the world’s production and distribution engines are still clogged with Covid cases around the world, with Chinese factories that are offline in order to keep workers home and protect them from Covid. And as that eases, we do expect that the availability of goods, and therefore their prices, will adjust and some of the inflation we’ll see will vanish. That said, we also know that both the U.S. and Canadian economies are reaching the point where labor markets are tight, where we’re seeing some wage inflation picking up, and there’s an element of inflation that unfortunately can’t be taken care of without taking steps to slow economic growth.

And so we’re looking for, for example, the Canadian economy to grow by about 3.5% or so this year, but we’re going to have to see a deceleration in 2023, and particularly by 2024, we’re going to have to see both the U.S. and Canada growing at not much better than 2%. And to do that, part of that job is going to be handled by the Central Banks, both the Federal Reserve in the U.S. raising interest rates beginning this year, the Bank of Canada doing the same.

Sitting here in mid February, it’s hard to be too certain about the precise timetable for those Bank of Canada rate hikes. They may well move in early March if Covid has eased up enough at that point to make that a reasonable decision, but certainly we expect rates to rise by about a full percentage point in both the U.S. and Canada this year. And that won’t be the end of the story, we’ll need some further rate hikes into 2023 and ultimately by 2024, short-term interest rates in both countries are likely to be a bit above 2%. So that’s still a gradualist path and if the Central Banks do this gingerly, they won’t be destroying growth in either country, only moderating the pace in order to prevent the unemployment rate from dropping to unsustainably low levels that would keep inflation elevated.

I think the surprise for many people will be that with some of the inflation disappearing on its own as supply chains improve and central banks slowing growth, we have a reasonable chance of seeing inflation rates not far from 2% by 2023. And that seems a long way away from where we are now, but it’s a sign that there are tools available to address this inflation pop. I don’t think we’re going to end up with a repeat of the 1970s, where we saw year after year of elevated inflation. We’ve learned a lot about how to manage economies to avoid that set of outcomes over the past decades, and I don’t see the Central Banks making the same mistakes that were made in the 70s that left us with persistent inflation. So, some facets of the 1970s may be with us these days. We’re seeing some OPEC pricing power. We’re even seeing some people looking at bell bottom jeans again, but 70’s style inflation and 70’s style stagflation won’t be with us if the central banks play their cards right.

How will the central banks know when their job is done? I think they’re going to be keeping a close eye, not on the overall inflation rate, which is being elevated by some of these supply chain issues, but on some of the guide posts for where longer-term inflation is headed. So they’re going to want to see for example wage inflation come down to about 3% in both the U.S. and Canada, and we expect it to be running above that pace in the first half of this year. So that’s part of what they’ll be looking at. And they’ll be looking particularly at the interest-sensitive sides of the economy, things like the housing market here in Canada, for example, to see whether they are starting to decelerate in the face of higher rates.

One factor that the Bank of Canada does have to take into account more so than the U.S. is that Canada’s household sector is carrying more debt than the average American relative to their respective incomes. That debt doesn’t roll over immediately. Much of it is locked into mortgages that don’t renew for a few years, but they’ll want to make sure that we don’t get hit with an economic sticker shock where we get to 2024 or 2025 and people who took on very cheap mortgages in 2020 start to feel the pain of that. They’ll want to see some of that pain, because they’re trying to slow economic growth ahead, but they’re going to have to make sure that rates don’t rise too abruptly in order to make sure that they don’t do too much damage to the health of the household sector. And for Canadians who are carrying a lot of debt, in a sense it’s misery loves company. The fact that there are other Canadians in a similar position makes it less likely that the Bank of Canada will overdo it on rate hikes and cause too much pain for those indebted Canadians.