This column by Armine Yalnizyan was originally published by the Toronto Star on Friday December 15, 2022. Armine is a Contributing Columnist to Toronto Star Business featured bi-weekly.
Fourth in a five-part series on our year of extreme inflation.
His words echo in my brain: “Of course it’s going to work,” he told me in an airport waiting lounge recently. “It’s The Plan. The Plan always works.”
“He” is none other than Tiff Macklem, governor of the Bank of Canada. Macklem has one job: price stability.
“The Plan” is raising interest rates to halt inflation. Any collateral damage — like increasingly unaffordable housing or lost jobs — is secondary to getting prices to stop wilding on us.
During the 108 years of recorded inflation in Canada, only 31 years have been guided by The Plan, an explicit monetary policy target to keep inflation in a range of one to three per cent.
Whether those decades are an anomaly, or the reliable recipe for achieving prosperity and stability, is the question. Will The Plan work? How long will it take?
Until the 1990s, nothing close to price stability existed.
The First World War caused massive price spikes. The early Roaring Twenties saw prices plummet, then recover. The Great Depression wiped out value, creating massive price deflation. The constant yo-yoing of prices brought ruin on farmers, industry and households alike.
People yearned for a plan. Progressives chafe at today’s central bank policies, but the push for the creation of a central bank came from progressives as well as banks and businesses.
The Regina Manifesto of 1933, birthed by farmers’ unions, immigrant settlement services and workers, prioritized price stability and a central bank to reduce the vagaries of capitalism.
The Americans created the Federal Reserve in 1913 in response to early 20th-century banking panics. Canada waited until 1935. We didn’t have the same banking failures, but needed a response to the economic chaos of the Great Depression.
Even then, the Bank of Canada didn’t use interest rates to stabilize prices at first.
Despite massive inflation, the bank rate stayed low, first to support the war effort, then to speed conversion from wartime production to a civilian economy.
Rates started rising in the late 1950s, but followed markets rather than led them.
In the 1960s, the biggest bite out of household budgets was food, not housing. Then, bank rates were double the pace of inflation, which sat at four to five per cent, but still didn’t tamp down growing appetites.
The central bank became more active, if inconsistently so, in the 1970s. As today, inflation was primarily a global story of oil price shocks.
In 1973, Nixon’s support of Israel during the Yom Kippur War sparked cuts in oil production by the Organization of Arab Petroleum Exporting Countries. Inflation in Canada hit 12.7 per cent by December 1974, rivalling wartime inflation rates.
The Bank raised rates until December 1974, then cut them.
Two years on, inflation was reduced by more than half, to 5.6 per cent. Thanks to interest rates? Unclear. The main inflation-fighting tool in the 1970s wasn’t monetary policy. It was fiscal policy. From 1975-1978 the Anti-Inflation Act limited profit margins, prices, dividends and worker compensation.
In 1979, the Iranian Revolution triggered turmoil in global markets. Like Russia’s invasion of Ukraine today, global oil prices doubled in 12 months. The Bank first hiked rates aggressively, to 16 per cent from 11.25 per cent in less than a year, then cut them to 10 per cent four months later. Inflation barely blinked.
Then everything changed. The Bank got serious about fighting inflation.
By August 1981, the Bank of Canada’s rate peaked at an eye-watering 21 per cent, just as inflation crested at 12.9 per cent. In 1982, the government introduced its inflation-fighting Six-and-Five program, but focused on wages, not prices; and only limiting wage growth of federal public sector workers, first to six then five per cent.
This marked the hand-off from fiscal policy to monetary policy as the main inflation-fighting tool, resonating with a new pro-business/anti-worker climate.
By the summer of 1983 inflation was cut in half, but the Bank had to cut its own rates in half, too. Triggering the biggest recession since the 1930s — the Canadian economy shrank from June 1981 to October 1982, as unemployment shot to a peak of 13.1 per cent from 7.2 per cent in roughly the same period — will do that.
In a way, the idea for The Plan was born in 1981. That’s when fighting inflation became Job One for the Bank of Canada, irrespective of economic trade-offs and human costs.
But it wasn’t until 1991 that the Bank of Canada officially embraced inflation targets of one to three per cent, becoming only the second central bank in the world to do so, after New Zealand.
The policy was adopted amidst a major recession. From March 1990 to April 1992 the economy shrank and unemployment rocketed to 12.1 per cent from 7.2 per cent by November 1992.
Bank rates had been inching up from 1987 to mid-1990, but inflation had only responded modestly, falling from just over five per cent to just over four per cent. By June 1990, when rates were at almost 14 per cent, the Bank started taking its foot off the gas. Inflation rose.
Then a funny thing happened on the way to price stability: bank rates fell, but inflation also fell, and dramatically, to 1.6 per cent from 6.3 per cent in just six months. Maybe because of The Plan. Maybe because of a major recession.
Prices settled into the band of one to three per cent inflation and stayed there for most of the next three decades. Inflation was tamed. Was it due to The Plan? Or China’s ascendance as the world’s largest cheap-labour factory?
The Plan could dance backwards, too. It kicked into reverse gear after 9/11, as the Bank dropped rates to prevent economic collapse. It took about a year to get inflation back to the target zone after prices stalled in the last months of 2001. The Global Financial Crisis of 2008 caused four consecutive months of price deflation. Lower rates brought inflation back into the target zone in about 18 months.
From one economic calamity to another, price stability was the sea we swam in from 1992 to 2020, when the pandemic hit. What can a central bank do when an economy is stopped in its tracks? You guessed it: lower the rate even more, to 0.25 per cent, which is what it did in March 2020.
Slowth (slow or no growth) after each of these shocks made it harder to raise rates, because higher rates slow economies. The risk is slowing the economy right into recession. It’s no easier when you have to fight inflation.
It’s good to have a Plan. But correlation does not causation make. Sometimes inflation falls because of rate hikes; sometimes not. Sometimes inflation falls 18 to 24 months after the Bank raises rates; sometimes more quickly; sometimes not at all.
Which brings us to this moment.
The bank rate is 4.25 per cent, after seven rate hikes from 0.25 per cent since March. While inflation still has the upper hand, at 6.9 per cent, its curve is bending away from June’s inflation peak of 8.1 per cent. Is The Plan working?
It’s still not clear to me that it is. Or that it’s the best or only plan. And it’s not just because I’m impatient.
First: prices are coming down in part because supply is returning. Oil prices fell to their lowest levels in 2022 last week, erasing the impact of Russia’s invasion of Ukraine. Shipping costs are down to pre-pandemic levels. Global exports are still down for basics like grains, oil seeds and fertilizer because of Russia’s aggression, but exporting nations like Canada are helping close the gap by punching above their weight. None of the “supply catching up” is due to higher interest rates slowing demand.
Second: We’ve just come through a 30-year juggernaut of low and lower prices, with China as the ox that pulled everyone’s cart. Supply chains are changing, for political and pandemic-related reasons. Every year there are more extreme climate events, impacting crop yields, transportation and electricity grids, herds and human health. Labour markets are tight anywhere there was a baby boom after the Second World War.
The governor reflected on these new realities during my conversation with him for this series, and since. While remaining “resolute” in raising rates until price escalation slows, this week Macklem also said: “These potential developments could make it harder to bring inflation back to the two per cent target and keep it there.”
That could mean even tougher monetary policy ahead. The Bank’s concern is not giving up the fight too soon, as in the 1970s.
That could also mean that fiscal policy ultimately plays a bigger role. Monetary policy is not the only tool to address the core problems we face.
What’s certain is The Plan is still The Plan. And The Plan doesn’t always work.
Next week: How wage growth shapes the inflation story.