Bank of Canada Governor Tiff Macklem attends a press conference in Ottawa on April 13. BLAIR GABLE / Reuters
The Bank of Canada says it has consistently underestimated the trajectory of inflation over the past year as a result of unexpected increases in world commodity prices and changing patterns of consumer spending that it did not fully take into account.
This misinterpretation of inflation means that it needs to be updated, aggressively raising interest rates and increasing the cost of borrowing to keep consumer prices out of control. It announced a full percentage point rate increase this week, the largest move since 1998.
In their Quarterly Monetary Policy Report published along with the rate hike, Bank of Canada economists attribute most of the blame for the fact that the price of commodities, especially oil, behaved very different during the last year than they had anticipated. They also say they underestimated the shift in consumer demand for goods and moving away from services during periods of confinement, as well as the speed with which the Canadian economy would recover from subsequent waves of VOCID infections. 19.
However, some analysts point to other factors, such as a misreading of how low unemployment could be before it triggered inflation and economic models that did not adapt to the unusual circumstances of a global economic shutdown.
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Errors in forecasts have a significant impact on monetary policy. As changes in interest rates take time to flow through the economy, central banks need to adjust their policy based on where they believe inflation will be for many quarters. This makes accurate forecasting important.
As the inflation rate began to rise last year, the Bank of Canada and many other central banks said the situation would be temporary. This influenced the bank’s decision to suspend the rise in interest rates until early March this year, when the annual growth rate of the consumer price index (CPI) stood at 5 , 7 percent. Since then, it has reached 7.7% in May, the highest since 1983.
Gov. Tiff Macklem acknowledged in an interview with the Financial Post published Thursday that, in retrospect, it would have been better to have raised interest rates earlier.
“If we had known everything a year ago that we know today, yes, we probably would have started raising interest rates a little earlier,” Mr. Macklem.
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“It simply came to our notice then. A year ago, there was still a lot of oversupply in the economy. The unemployment rate was around 7.5% last summer. We were still in the middle of the virus waves. “
According to the bank’s analysis, about 40 percent of the deviation between its April 2021 CPI forecast and real CPI inflation in the second quarter of 2022 was the result of prices of unexpectedly high raw materials. The most important factor was oil prices, which rebounded in 2021 and then rose after Russia invaded Ukraine. Prices of agricultural raw materials were also higher than expected as a result of last summer’s drought and war in Ukraine.
The bank attributed another 20% of its forecast error to stronger-than-expected asset prices. COVID-19 disrupted global manufacturing and transportation networks, causing shortages and higher shipping costs. This was exacerbated by a shift in consumer spending on goods and away from face-to-face services during confinements.
Another 20 per cent of forecast errors were attributed to the faster-than-expected recovery of the Canadian economy following the recession at the start of the pandemic. It was a very atypical fall, the bank noted. Income and consumer confidence grew during the pandemic, thanks in part to low interest rates and significant support from the federal government to households and businesses.
“The large accumulation of savings, low mortgage rates and changes in the preferences of home buyers caused house prices to grow more than expected given the amount of flow in the economy.” , said the bank in the Monetary Policy Report. “The sharp rise in house prices has boosted consumer price index inflation by an average of 1.2 percentage points since mid-2021.”
Claire Fan, an economist at the Royal Bank of Canada, noted that many economists struggled with forecast errors over the past year because their models developed over a long period of low inflation and were not calibrated to account for major supply disruptions like these. which has happened over the last two years.
The recession “was a truly unique situation that was not triggered by a fundamental weakness underlying the economy, but rather by a closure designed to stop the spread of the pandemic,” Ms. Fan said in an interview. “So in this kind of unique situation, it’s not uncommon to see models that explicitly used data from the past to predict the future fail.”
Stéfane Marion, chief economist at the National Bank, said the Bank of Canada’s assessment of its own forecast errors should be taken with a grain of salt.
“I think it’s too easy to blame the external factors of two-thirds of your fault,” he said in an interview. “There is a serious lack of transparency when it comes to their analysis of Canadian labor markets.”
He noted that the bank does not publish its unemployment forecast, which makes it difficult to assess the extent to which it was at the time of assessing the tightness of the labor market. Economists believe the rampant inflation of the 1970s was caused in part by incorrect central bank beliefs about the low that unemployment could be before it causes inflation.
“What was your forecast for potential output and the natural unemployment rate?” said Mr. Marion. “Unless you show that forecast, how are you supposed to convince me that your inflation error is based on external factors? You’re not showing me the internal assumptions that were made for the domestic economy.”
The bank released an updated inflation forecast on Wednesday. He now expects the inflation rate to average 7.2% in 2022 and 4.6% in 2023, considerably higher than expected in April. He does not expect inflation to return to its 2 percent target by the end of 2024.
Some economists have said the bank misinterpreted the trajectory of inflation because it did not pay enough attention to the amount of money in circulation. The money supply expanded significantly in 2020, in part as a result of the Bank of Canada’s program to buy federal government bonds, which was used to further reduce interest rates.
The central bank has not focused on money supply when making monetary policy decisions since the 1980s. In his interview with the Financial Post, Mr. Macklem seemed to reject the idea that the bank’s forecast errors were due to a lack of attention to money, which he said was “not always such a reliable indicator” of inflation.
“You definitely want to keep an eye on money, but ultimately, what you have to look at is where the demand for the economy is, in relation to the ability of the economy to produce the goods and services that people want. And if supply cannot keep up with demand, you will get inflation, ”Mr Macklem.
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