The Bank of Canada has been on an unprecedented path of rate increases, raising its interest rate from 0.25% in March 2022 to 5.00% in July 2023. The central bank took this aggressive stance in response to surging inflation, which has been a persistent concern since midway through the COVID-19 pandemic. While the initial inflationary pressures were attributed largely to supply chain disruptions, they have been further fueled by robust consumer demand and a stronger-than-anticipated employment rebound.

Benjamin Tal’s Perspective

Benjamin Tal, Chief Economist for CIBC Capital Markets, is known for his accuracy in economic assessments and predictions. His July 21 research note sheds light on the Bank of Canada’s approach to managing inflation and economic growth. According to Tal, the central bank faces an asymmetric choice: either deal with inflation or risk a recession. In this scenario, central banks, including the Bank of Canada, prefer to tackle a recession as they have more experience and effective tools to address it. Rising inflation expectations are seen as a central banker’s worst nightmare.

The Bank’s Bias and Path to Overshooting

Tal points out that the Bank of Canada’s current bias toward shutting down inflation means that it may be giving more weight to strong economic indicators. With this bias, the central bank may be more inclined to overshoot its response to economic data, leading to potential challenges down the line. In fact, Tal suggests that the Bank may have already started overshooting in June 2023, consistent with its bias.

Strategic Positioning and Forecasting

The Bank of Canada’s recent relatively bullish GDP growth projections and deferral of reaching the inflation target are not just mere forecasts; they are strategic moves. By upgrading the GDP forecast, the Bank aims to limit the need for immediate reactions to strong economic indicators. Additionally, postponing the timeline to achieve price stability allows the Bank to buy time and manage inflationary pressures with a limited risk of increasing long-term inflation expectations.

Disinflationary Forces at Play

Tal identifies several significant disinflationary forces that may come into play. Firstly, the ongoing improvements in supply chain conditions are expected to enhance monetary policy effectiveness and reduce retailers’ gross margins, contributing to less externally oriented inflation. The decline in the US Producer Price Index (PPI) is also noteworthy, primarily driven by reduced gross margins for wholesalers and retailers as supply chains improve.

Services Inflation and Labor Market Dynamics

Regarding services inflation, much depends on the labor market. While there has been a decline in the number of job vacancies, they still remain significantly higher than pre-COVID levels. Normally, such a labor shortage would lead to strong wage performance in low-wage occupations. However, the wage ratio of low-wage occupations to higher-wage occupations does not indicate any significant upside trend, raising questions about the tightness of the labor market.

Underestimation of Labor Supply

One reason behind the lack of significant wage growth in low-wage occupations could be the underestimation of labor supply in official labor market statistics. Non-permanent residents might be significantly undercounted in the Labour Force Survey, leading to a perception of a tighter labor market than is actually the case.

Future Rate Hikes and Disinflationary Expectations

The Bank of Canada may continue its rate hike trajectory in September, but Benjamin Tal suggests that the current disinflationary forces will become too evident to ignore. Even a biased central bank will need to consider these forces in its future policy decisions.

To wrap up, the Bank of Canada’s rapid rate increases have been driven by the goal of curbing inflation, but concerns are emerging about potential overshooting and the influence of disinflationary forces. As economic dynamics continue to evolve, finding the right balance between managing inflation and supporting economic growth remains a challenging task for the central bank.