War impact, lending boom mean inflation expectations will likely rise despite latest rate hike

In the current roar of highinflation, last week's quarter-point increase in interest rates by the Bank of Canada will likelybe a whisper too quiet for most Canadians to hear.

According to a flurry of statements and speeches, including testimony to a parliamentary committee, the central bank's governor, Tiff Macklem, has begunhis long-awaited attack on inflation that's meant to convince Canadians they should not expect price rises to continue.

Rate hikes, the Bank of Canada governor said,were "needed to keep inflation expectations well anchored and to limit the broadening of inflationary pressures so that inflation falls back as supply disruptions ease."

Markets send a different message

But while the central bankbattles to quell inflation expectations, the world economy is conspiring to senda very different message.

Russia'sattack on Ukraine has driven energy prices sharply higher, and Canadians who have not yet invested in an electric vehiclehave never seen pump prices at this level.Global food prices are expected to surge as grain and fertilizer suffershortages.

The loss of production from an entire country, Ukraine, and economic sanctions levelled by the West against Russiahave added new distortions to supply chains, already the main villain inMacklem's inflation story.

That contradictorymessage that you should expect inflation to continue to rise, not fall isn't just coming from outside the country. Last week,Canadian banks reported anew surge in lending, pouring more money into the country's overheated economy. If fear of a future stream of increasing central bank interest rates was supposed to deter borrowers, it hasn't convinced themyet.

Not only doworld markets seem to be colludingagainst Macklem,but the central bank itself is implicated in rising prices.Economists say the increase in rates themselveswill actual lead to an increase in inflation, as the rising cost of payments on huge mortgages begins to show up inthe consumer price index (CPI).

As Al Ullman, the late U.S. politician who chaired the House ways and means committee,once said in 1980, when inflation was hovering at around13 per cent:"To depend on monetary policy to slow the economy by increasing interest rates adds to inflation because that increase goes into the cost of everything we buy."

It's happening again

Well-known Canadian economist Eddy Ng, the Smith Professor of Equity and Inclusion in Business at Queen's University in Kingston, Ont., said the same thing is happening again today.In fact, he said, that's the intent ofrate increases.

"The conventional wisdom is to raise interest rates because that will make it more expensive for consumers and businesses to borrow, and hopefully that would stop the consumption," Ng said in a phone interview last week after the bank's rate hike.

"I think that's a fundamental misreading of the economy," he said.

Ng saidthe problem now isa shortage of supply and raising borrowing costs will merely make it harder for businesses to contribute to filling thosesupply gaps.

The other peculiar thing about the effect of rising interest rates on mortgages, he said, isthat while rising house prices are considered an increase in asset value and therefore not counted in inflation,the higher level of interest paid on those large mortgages feed straight into the CPI as part of Statistics Canada's shelter component.

From his series of speeches and appearances last week, it's clear that Macklemrealizes he faces clashingforces that are hard to reconcile.

Asked by Quebec MP Gabriel Ste-Marie, a member of the finance committee,if he's worried about stagflation a recession combined with rising prices as some economists have predicted,Macklemsaid he was not, predicting that the Canadian economyseen growing at a surprisingly strong 6.7 per cent in the latest quarter will continue to surge this year and next.

Although he did not appear at either event, Canadian economist David Rosenberg'sworry that rising rateswould "kill the Canadian economy" popped up twice:in questions at Macklem's parliamentary committee appearance and at a news conference with business reporters.

"We think the economy can handle higher interest rates," Macklem responded."We think the economy needs higher interest rates."

Convincing consumers

The harder question is the one about consumer inflation expectations. As repeatedly stated by Macklem and by Jerome Powell, his counterpart at the Federal Reserve Bank in the United States, central banks want tostop consumers and businesses from expecting that priceswill rise.

"What monetary policy can do is make borrowing more expensive, which slows domestic demand," Macklemsaid in one of his speeches last week. "For households and businesses that are already feeling the pinch of inflation, the higher cost of borrowing can be doubly painful. But tighter monetary policy is necessary to lower the parts of inflation that are driven by domestic demand."

WATCH | Bank of Canada boosts interest rate in attempt to curb inflation:

Bank of Canada hikes interest rate in attempt to curb inflation

3 years ago

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The Bank of Canada is raising interest rates for the first time since 2018 to try to curb inflation, but the rate hike could add to the financial strain of people already struggling.

But as the bank governor squarely admitted, he may be facing overwhelming odds in trying to changethe view of consumers. He expects the world price of oil alone, which continued to trade above $110 US a barrel, could push the price of Statistics Canada'sbasket of consumer goods sharply higher.

"If a price of $110 were to be maintained, you could expect that that would add about another, further, percentage point to inflation," said Macklem, who observed that not only oil but other commodities and manufactured goods had risen in price due to Russia's invasion of Ukraine.

"Since the invasion, we've seen a lot more volatility in these prices.I'm not going to give you a new forecast, but what's pretty clear is that they are going to add further to inflation in the near term, and we can expect inflation to be higher in the near term as a result."

So much for reducing our expectations.

Friday's jobs numbers will offeranother readingon the strength of the Canadian economy. But with a soaring need for the export of Canadian commodities, a rising demand for workers,a surge of new borrowing and investment,GDP growth at multi-year highs, ahousing market that just won't quitand what Macklem called "solid momentum" in domestic demand, it is clear that a whisper of rising interest rates will not be enough to slow down the party.

Macklem willhave to shout.

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