Inflation and increase of the Policy Interest Rate: should we fear a recession?

Gasoline, food, furniture, etc.: price increases are everywhere and affect us all, individuals and businesses alike. Fueled by the pandemic and the war in Ukraine, inflation is at its highest level in decades. Faced with this context, many economists agree that the risks of recession are on the rise. Are they right to worry? If the Bank of Canada fails to maintain balance while raising interest rates, probably. Let us explain why.

Where does current inflation come from?

Let’s start at the beginning.

Before we even explain what’s caused the current inflation, let’s see what inflation itself consists of. So, what is inflation? The Bank of Canada defines it as “a persistent rise in the average level of prices over time”.

It is calculated using the Consumer Price Index (CPI), which is based on the variation in the cost of a fixed basket of goods and services, the composition of which reflects targeted spending by the Canadian population. Basically, we compare the price of this fictional basket in year X with that of the same basket in year Y and we can thus assess whether the CPI has changed or not.

Now that that’s out of the way, let’s talk about the inflation we’re experiencing right now. What are the causes? To sum it up in a few words, we could say that the demand is greater than the supply.

Indeed, with the current economic recovery, people are starting to eat out again, to shop, to travel. In other words, to spend! However, businesses are struggling to meet the rapidly increasing demand due to disruptions in supply chains caused by the pandemic and the war in Ukraine.

In addition, imports from all over the world having rebounded, the demand for maritime transport of goods has increased significantly and rapidly, causing a shortage of containers, and therefore, an increase in transport costs. This increase is also accentuated by the rise of energy costs, gas in particular.

All of these factors combined have resulted in the rapid price progression that we have seen lately. To better comprehend the situation, know that Canadian inflation reached 6.8% last April.

How to control inflation?

It is the role of the Bank of Canada to control inflation; by raising the Policy Interest Rate,  it can curb the increase in the CPI.

Thus, last April, the Bank of Canada raised the Policy Interest Rate, taking it from 0.5% to 1%, the biggest increase in more than 20 years. It then proceeded with a second increase this year, the Policy Interest Rate reaching 1.5% as of June 1, 2022.

But it is not over! At 1,5%, the Policy Interest Rate is still overstimulating economic activity… We can expect further gradual increases throughout the year. How much will the policy rate increase? Some specialists expect it to be at least two percentage points, with the aim of bringing inflation back to the 2% target.

How is the Policy Interest Rate related to inflation?

The Policy Interest Rate influences the interest rates used by banks to finance loans. Thus, the increase in the Policy Interest Rate has the effect of raising mortgage rates and borrowing rates in general, in order to discourage loans and spending.

By encouraging, or even forcing, people to reduce their spending, inflationary pressures and pressure on production chains will, in theory, be reduced.

However, this effect is not instantaneous! It takes anything between six months and two years for us to really feel the concrete impact of these measures on inflation… Ouch!

So why not raise the key rate now?

Because it is a delicate operation to maintain the balance! What do we mean by “balance”? To properly illustrate, let us describe the effects of the imbalance that would occur if…

1- The Canadian Central Bank raised the key rate too quickly
If the Policy Interest Rate rises too suddenly, homeowners could have a hard time making their mortgage payments, which is already a problem in itself! Moreover, this could force them to restrict their purchases in other spheres, thus affecting the demand for these goods and services, which, ultimately, could cause… a recession!

2- The Canadian Central Bank raised the key rate too slowly
On the other hand, if the policy rate is raised too slowly, inflation may remain high and last much longer than expected. The prices of goods and services will then continue to rise, followed by wages…fanning the flames of inflation by increasing the costs for companies which will then proceed to increase prices… and so on. A true vicious circle!

In light of these two scenarios, you are able to understand the importance of maintaining the delicate balance between inflation, control of the CPI and recession.

Therefore, the Bank of Canada is currently targeting a theoretical “neutral” rate of around 2.5%. This would allow the economy to grow without causing inflation.

Is a recession the solution to inflation?

By definition, a recession is the exact opposite of inflation. It is characterized by negative economic growth for at least two consecutive quarters and is accompanied by an important drop in consumption and investment that can last a few months or several years.

So, is this the solution to get out of this inflationary period?

No, because a recession causes a lot of damage such as job losses, a rise in the unemployment rate, bankruptcies and a drop in the standard of living. Moreover, a recession is uncertain: you cannot predict what it will look like or how long it will last. In short, nothing desirable!

In conclusion, is a recession inevitable? Not if the Bank of Canada does things right, which means a gentle increase (but not too much) in the Policy Interest Rate which would make it possible to curb inflation, without curbing economic growth. Will they succeed? Only time will tell…