OTTAWA –
Canadians are seeing the cost of borrowing rise rapidly as the Bank of Canada takes historic action to slow the spike in prices after learning expensive lessons from history when central banks let inflation run wild.
The Bank of Canada recently raised its key interest rate by a full percentage point — the largest single rate hike in more than two decades — as it tries to cool domestic demand and lower inflation expectations.
An unusual move at an unusual time: Inflation hit a 39-year high of 8.1 percent in June after years of a low, stable and predictable CPI in Canada.
But for most of the 20th century, price stability was not a given in the Canadian economy.
TD Chief Economist Beata Karantzi said inflation could feel particularly challenging today because Canadians have been sheltered from inflation volatility for decades.
“We haven’t had this challenge in a while,” Karantzi said.
Canada’s last experience with high inflation came in two waves in the 1970s and 1980s, peaking at 12.9 percent in 1981.
In 1973, inclement weather caused global food shortages and the OPEC oil embargo sent energy prices soaring. A few years later, a second energy crisis was triggered by the Iranian Revolution of 1979.
And while the drivers of high inflation are relatively similar – global circumstances are pushing up food and energy prices – inflation today is not expected to rise as high or be as sustained.
That’s because central banks’ approach is now vastly different, said Western University economics professor Stephen Williamson.
“The big difference now is sort of a strong perception that the Bank of Canada’s job is mostly to take care of controlling inflation,” Williamson said. “In the 1970s, that wasn’t true.”
For most of the 20th century, central banks have yet to develop strong and effective mandates to maintain stable inflation accounting, Williamson said. Instead, they tried to control inflation through the money supply.
Economists at the time believed that inflation could be managed by controlling the amount of money circulating in the economy. However, central banks have found this tactic unsuccessful.
Carantzi said another reason the Bank of Canada has been slow to raise interest rates is that central banks have historically been hesitant to stop economic growth through higher interest rates.
TD Senior Economist James Orlando wrote an analysis in April that compared today’s high inflation to inflation in the 1970s and 1980s. He said the Bank of Canada was slow to raise interest rates in the 1970s and by the time the bank acted, it was too late.
“Inflation expectations have been adjusted upwards, leading to even higher inflation in the coming years,” Orlando said.
Interest rates in the 1980s eventually rose to 21 percent.
In 1982, the Bank of Canada announced that it would no longer target the money supply and would instead shift its focus to interest rates.
Canada’s turbulent experience with high inflation also led to the Bank of Canada’s mandate to maintain a target inflation rate. In 1991, the Bank of Canada and the Minister of Finance agreed on an inflation-controlled framework to guide monetary policy.
“We believe the Bank of Canada has learned from history,” Orlando wrote in his comparison of inflation in the two eras.
This time around, Canada’s central bank still faces criticism that it took too long to start raising its key interest rate. By comparison, however, the Bank of Canada is moving faster and stronger.
“Today we hear a different dialogue from the central bank, that there is a willingness to sacrifice growth and even raise the unemployment rate,” Karantzi said.
In the latest interest rate announcement on July 13, which surprised economists who had expected a three-quarters of a percentage point hike, the central bank’s message was clear: it is not afraid to act aggressively to curb skyrocketing inflation.
At the same time, economists such as David McDonald of the Canadian Center for Policy Alternatives have used history to warn that raising interest rates too quickly could trigger a recession, as happened in the 1980s.
However, Carantzi said there are important differences between the two time periods, including a different makeup of the economy and the existence of safeguards such as mortgage stress tests.
“The challenge with making period comparisons, especially when you go back so far in history, is that there are so many differences in the game,” Karantzi said.
In May, Bank of Canada Deputy Governor Tony Gravel gave a speech that focused on why comparisons between the stagflation of the 1970s and the current inflationary environment are “unwarranted,” citing strong economic growth, a tight labor market and historically low unemployment.
And of particular importance, Gravel said today’s Bank of Canada is equipped with the policy tools it needs to tame inflation.
“Since the 1990s, we and other central banks around the world have had success with inflation targeting,” he said. “And we are committed to getting inflation back to target.”
This report by The Canadian Press was first published on July 21, 2022.
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