Article 61360 New study finds Bank of Canada campaign to raise rates will likely trigger a recession

New study finds Bank of Canada campaign to raise rates will likely trigger a recession

by
Jacob Lorinc - Business Reporter
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The rate of inflation had jumped to nearly 12.5 per cent, so at a hurried press conference in Calgary, the governor of the Bank of Canada warned reporters and financial analysts that interest rates were going up again.

Until progress can be made in bringing inflation down, interest rates will have to remain high," Gerald Bouey told the crowd at the Men's and Women's Canadian Clubs.

It was September 1981 - consumer prices were soaring, unions were demanding higher wages, and the Iranian revolution had sparked a global oil shortage that sent the price of fuel skyrocketing. The only way to help temper the chaos at home, Governor Bouey held, was to make it harder for Canadians and businesses to borrow.

In the two years that followed, the bank's strict monetary policy helped lower inflation by nearly 8.5 per cent. But it also helped trigger a recession. As interest rates climbed, the national GDP shrank for months on end while the unemployment rate rose to 12 per cent - 860,000 Canadians out of work.

Four decades later, the Bank of Canada is again wrestling with high inflation, this time a product of pandemic-driven consumer demand and Russia's invasion of Ukraine, which has prompted global shortages of grain and oil. While the central bank has already hiked interest rates three times this year - with another hike expected in July - policymakers are hoping they can engineer a soft landing" for the Canadian economy that cools consumer prices without provoking a recession.

But if history is any guide, the likelihood of achieving that soft landing is low - if not outright impossible, according to a new analysis from the Canadian Centre for Policy Alternatives.

The study, authored by senior economist David Macdonald, finds that the Bank of Canada has a zero per cent success rate" of quickly raising interest rates without causing a recession.

There is simply no historical precedent for the Bank of Canada engineering a soft landing.' Each time the Bank of Canada has attempted such engineering through rapid interest rate hikes - which it appears to be set on doing now - it has resulted in a crash landing," said Macdonald.

Today, the Bank of Canada wants to see inflation fall by roughly 5.7 per cent - from its May value of 7.7 per cent to its target of two per cent.

Macdonald's study found only three instances in modern Canadian history when the central bank lowered inflation by 5.7 per cent or more by raising interest rates: once in the mid- '70s, again in the early '80s and finally in the early '90s.

In each of those periods, high interest rates helped steer the economy into painful recessions that left workers without jobs. The economy fell into recession in 1974, after the bank helped lower inflation by seven per cent; in 1981, when inflation fell by 8.5 per cent; and in 1990, when inflation fell by 5.8 per cent.

In the worst of those recessions, between 1981 and 1983, the employment rate fell by 4.2 per cent. With today's population, the study found, that drop would be the equivalent of putting 1.3 million Canadians out of work.

If a pilot told me that she'd only ever attempted a particular landing three times in the past 60 years with a zero per cent success rate, that's not a plane I'd want to be on," Macdonald said.

The solution? Move the goalposts, he said.

Though central banks have committed to keeping inflation at a moderate two per cent for much of the 21st century - a target that appears to derive from economists at New Zealand's central bank in the late '80s - Macdonald and other economists have argued that countries like Canada could withstand a slightly higher rate of inflation without hurting the economy.

Britain adopted a four per cent inflation target in the early '90s, for instance, while some prominent economists called for the U.S. Federal Reserve to adopt a four per cent target following the 2008 financial crisis.

By raising Canada's target inflation rate to four per cent, while still seeking to lower inflation from 7.7 per cent, the Bank of Canada would have a much better chance of avoiding a recession, Macdonald's study concluded.

Instead of bringing inflation down by 5.7 per cent, the bank would only have to lower inflation by 3.7 per cent to meet a four per cent target. And in the six times that inflation has fallen by 3.7 per cent over the past 60 years, the Bank of Canada successfully engineered a soft landing twice: once in 1969-70, and again in 2003-04.

With a goal of four per cent, then, the success rate of reaching inflation reduction without a recession would increase to 33 per cent," said Macdonald.

But the central bank has not signalled any intention to change its two per cent target, suggesting that interest rates are likely to rise higher until inflation falls by 5.7 per cent or more.

May's high inflation figures were buoyed by high gas prices, grocery costs and housing prices. Economists broadly expect inflation to rise again - possibly to eight per cent or more - when Statistics Canada releases its June data this month.

The Bank of Canada has acknowledged that a recession could be on the horizon. In a press release Monday, the bank noted that different households experience economic downturns differently depending on income, gender, age, race and other factors.

When the economy hits a rough patch, consumption tends to fall. Businesses then cut production, leading to more job losses and a deeper downturn. So it's critical for governments and central banks to understand what's happening at the household level. This helps them better tailor their policies to cut the length and depth of recessions," the bank said.

The Bank of Canada is expected to raise interest rates again on July 13.

Jacob Lorinc is a Toronto-based reporter covering business for the Star. Reach him via email: jlorinc@thestar.ca

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