Canadians are seeing the cost of borrowing rise rapidly as the Bank of Canada takes historic action to slow soaring prices, learning from history when central banks let inflation run wild.
The Bank of Canada recently raised its key interest rate by a full percentage point — the biggest single rate hike in more than two decades — as it seeks to cool domestic demand and lower inflation expectations.
An unusual move for an unusual time: Inflation hit a 39-year high of 8.1 percent in June, after years of low, stable and predictable consumer price index activity in Canada.
But for most of the 20th century, price stability was not a given in the Canadian economy.
TD Chief Economist Beata Caranci said today’s inflation could be particularly challenging because Canadians have been shielded from inflation fluctuations for decades.
“We haven’t had a challenge like this in a long time,” Caranci said.
Canada’s last experience with high inflation came in two waves during the 1970s and 1980s, peaking at 12.9 percent in 1981.
In 1973, severe weather caused global food shortages and the OPEC oil embargo sent energy prices soaring. A few years later, the Iranian revolution in 1979 triggered a second energy crisis.
And while the causes of high inflation are relatively similar – global circumstances are pushing up food and energy prices – today’s inflation is not expected to be as high or as persistent.
That’s because the approach of central banks is now markedly different, said Western University economics professor Stephen Williamson.
“The big difference now is there’s a kind of entrenched notion that it’s mostly the Bank of Canada’s job to take care of controlling inflation,” Williamson said. “That wasn’t true in the 1970s.
For most of the 20th century, central banks had yet to develop strong and effective mandates to maintain a stable rate of inflation, Williamson said. Instead, they tried to control inflation through the money supply.
Economists at the time believed that inflation could be controlled by controlling the amount of money circulating in the economy. However, central banks found this tactic unsuccessful.
Caranci said another reason the Bank of Canada was slow to raise rates was that central banks have historically been hesitant to hinder economic growth through higher interest rates.
TD Chief Economist James Orlando wrote an analysis in April that compared today’s high inflation to the 1970s and 1980s. He said the Bank of Canada was slow to raise interest rates in the 1970s and when the bank started to act, it was too late.
“Inflation expectations have been adjusted upwards, resulting in even higher inflation in the coming years,” Orlando said.
Interest rates eventually rose to 21 percent in the 1980s.
In 1982, the Bank of Canada announced that it would no longer focus on the money supply and instead focus on interest rates.
Canada’s turbulent experience with high inflation also led to the mandate of the Bank of Canada to maintain an inflation target. In 1991, the Bank of Canada and the Minister of Finance agreed on an inflation-driven framework to guide monetary policy.
“We believe the Bank of Canada has learned from history,” Orlando wrote in his comparison of inflation in the two eras.
The Bank of Canada is still facing criticism this time around that it took too long to start raising its key interest rate. In comparison, however, the Bank of Canada has acted more quickly and forcefully.
“We are hearing different dialogues from the central bank today that there is a willingness to sacrifice growth and even let unemployment rise,” Caranci said.
In its latest rate announcement on July 13, which surprised economists who had expected a three-quarter percentage point hike, the central bank’s message was clear: it is not afraid to act aggressively to curb skyrocketing inflation.
At the same time, economists like David MacDonald of the Canadian Center for Policy Alternatives have used history to warn that raising rates too quickly could trigger a recession, as happened in the 1980s.
But Caranci said there are important differences between the two time periods, including the different makeup of the economy and the existence of safeguards such as mortgage stress tests.
“The problem with comparing periods, especially when you get this far back in history, is that there were so many differences in the game,” Caranci said.
In May, Bank of Canada Deputy Governor Toni Gravelle gave a speech that focused on why comparisons between stagflation in the 1970s and the current inflationary environment were “unwarranted,” citing strong economic growth, a tight labor market and historically low unemployment.
Most importantly, Gravelle said today’s Bank of Canada is equipped with the policy tools it needs to control inflation.
“Since the 1990s, we and other central banks around the world have been successful with inflation targeting,” he said. “And we are committed to getting inflation back to target.”
This report by The Canadian Press was first published on July 21, 2022.
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