Remarks by Tiff Macklem
Governor of the Bank of Canada
CFA Québec
February 7, 2023
Québec, Quebec
Monetary policy at work
Introduction
Good afternoon. It's a pleasure to be here in
Québec to speak to you about
monetary policy and the economy. As we approach the three-year mark of the
COVID-19 pandemic in Canada, we are also entering a new phase in monetary
policy.
In 2022, we faced an overheated economy and high inflation, and we responded
forcefully, increasing our policy interest rate rapidly. The year ahead will be
different. In January, after eight consecutive interest rate increases, we said that
we expect to hold the policy rate at its current level, conditional on the outlook for
inflation. We are pausing to assess how well our interest rate increases are
working to bring inflation down. With inflation above 6%, we are still a long way
from the 2% target. But inflation is turning the corner. Monetary policy is working.
That's what I'd like to talk about
today-how, exactly, monetary policy works to
I'll outline what we've done so
control inflation. far, what the impact has been and
what we expect going forward. I also want to talk about the risks and
uncertainties that we are facing as we work to get inflation back to target.
Canadians know inflation is high. They see it at the grocery store, when they pay
we've
their rent and when they go to a restaurant or on a trip. And they know that
increased interest rates. They see that in higher costs for borrowing-in
mortgage rates, lines of credit and business loans.
But it is less obvious how higher interest rates are working to bring inflation
Since March, we've raised the policy rate by
down. 41⁄4 percentage points. In
recent months, inflation has levelled off and has begun to ease. The considerable
tightening we've
done will continue to work its way through the economy, and this
will rebalance demand with supply and slow inflation. So how does this work?
The transmission mechanism
On the face of it, the Bank's
approach to monetary policy is simple. We're an
and that's about
inflation-targeting central bank. We have a 2% inflation target,
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where inflation has been, on average, for 30 years-at least until the pandemic
hit. When inflation strays from that target, we have one main tool to get it back to
2%-the policy interest rate. During times of crisis, we can use other tools, but
usually we have one target and one tool.
In practice, monetary policy is made more complicated by at least three realities.
First, the influence of our policy interest rate on inflation is indirect. Second, it
takes time to work-up to two years to have its full effect-and over that time,
new developments will buffet the economy and inflation. Because monetary
policy takes time, we have to try to look ahead to where inflation will be. And
third, because we know new developments will always arise, we need to be
humble about our forecasts and prepared to adjust to changing circumstances.
Economists have a fancy name for the process through which changes in our
"the monetary policy transmission
policy rate affect inflation-they call it
same whether we're raising rates or
mechanism." This mechanism works the
lowering them. But since we've been raising interest rates, let's talk about that
(Figure 1).
Figure 1: The transmission mechanism of monetary policy
When we raise the policy rate, it immediately costs more for banks to borrow
from each other or from us. In response, they increase their rates for loans and
deposits. That means that people get a higher return on their savings. But it also
means they pay more interest on loans.
Higher interest costs discourage people from borrowing. That might mean fewer
people take out a mortgage to buy a home. They might delay buying a new car
because the loan is more expensive. Or they might put off that kitchen renovation
That's why
or family vacation. sectors that are sensitive to interest rates, like
a pretty
housing, are often the first to slow when we raise interest rates-it's
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direct channel. We also typically see demand for big-ticket items like cars and
household appliances slow because people often borrow money to buy them.
Higher rates also have knock-on effects further into the economy. Construction
slows down. Households with mortgages have less money to buy other things.
Production slows down as demand weakens. Businesses may cut their
investment plans because the cost of borrowing has gone up or demand has
fallen off.
Higher Canadian interest rates also make Canada more attractive to foreign
investors. That means that, if everything else stays the same, the Canadian
dollar will rise. This makes foreign goods less expensive for Canadians to buy, so
the country imports less inflation. And it makes Canadian exports more
expensive in foreign markets, slowing international demand for these goods and
services.
So higher policy rates mean lower demand at home and from abroad. And with
less demand, growth in our economy slows. That doesn't sound like a good
thing, but when the economy is overheated, it is. When demand runs ahead of
supply, inflation faces upward pressure. Slowing the economy lets supply catch
up with demand, and that relieves inflationary pressures.
Monetary policy also influences expectations of future inflation. That's important
because inflation today is also affected by what people think inflation is going to
be in the future. Let me explain. If households and businesses think inflation is
going to be low, businesses will be cautious about raising their prices out of fear
that they will lose customers. And that keeps inflation low. But when consumers
be high, businesses don't worry as much that higher prices will
think inflation will
scare off customers, so they are more inclined to raise them. That's why we have
been so determined to keep inflation expectations well anchored at the 2%
inflation target. We do that mostly through communication-by being crystal clear
we are committed to restoring price stability-and by backing those words with
action.
To summarize, the Bank directly controls only the first step-the change in the
policy rate. The other steps in the transmission mechanism are less direct, and
they take time to have their full effect.
Impact of higher policy rates so far
When we began raising rates in March 2022, the economy was reopening after
the fourth wave of the COVID-19 virus. As momentum built in the months that
followed and the economy moved clearly into excess demand, we increased
Russia's unprovoked attack of Ukraine in
rates in unusually large steps. February
also sent global energy and food prices sharply higher, which added
considerably to inflation in Canada.
We've been raising rates for almost a year
now-from 1⁄4% to 41⁄2%. And we are
seeing their impact.
Borrowing rates and the exchange rate
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Increases in the policy rate have raised borrowing rates for households and
businesses (Chart 1). The average five-year variable mortgage rate rose from
1.5% to 5.9% between January 2022 and January 2023, and the average
fiveyear fixed mortgage rate rose from 2.8% to 5.1% over the same period. The
prime rate, which is a benchmark for business loans, rose from 2.5% to 6.5%,
and longer-term corporate borrowing rates are up about 2 percentage points.
Chart 1: Borrowing costs have risen
%
7 7
6 6
5 5
4 4
3 3
2 2
1 1
0 0
Policy rate Five-year variable mortgage rate Long-term corporate borrowing
rates
January 2022 January 2023
Note: Values are monthly averages. Long-term corporate borrowing rates reflect rates on investment-grade corporate bonds.
Sources: Bloomberg Finance L.P., Lender Spotlight and Bank of Canada Last observation: January 2023
Changes to our policy rate have also affected the exchange rate. But the
exchange rate channel has been more muted than usual. Because the
US Federal Reserve was also raising rates rapidly through 2022, the
Canadian dollar did not appreciate against the US dollar. It did rise initially
against other currencies-like the euro-until these jurisdictions also began
forcefully raising their policy rates. This fight against inflation is a global one-
we're not fighting it alone.1
After 11 months of policy rate increases, we're seeing signs that higher interest
rates are beginning to rebalance the economy. Household spending has
moderated, particularly in interest-rate-sensitive sectors. The labour market
remains tight, but early signs of easing are evident. Inflation has declined, and
our surveys of inflation expectations suggest more businesses are convinced that
inflation will recede. Let me talk about each of these impacts in turn.
Interest-sensitive spending
The first place we saw the effects of rate increases was in housing activity. When
we began raising rates, Canadians with variable interest rate mortgages and
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those looking for a new mortgage felt it first. Nearly a year later, people renewing
their home loans are also facing higher interest costs. Demand for mortgages
has fallen, and housing activity has weakened sharply from unsustainably high
levels (Chart 2).
Chart 2: Housing activity has weakened
Ratio of sales to new listings, seasonally adjusted, monthly data
%
90 90
80 80
70 70
60 60
50 50
40 40
2017 2018 2019 2020 2021 2022 2023
Source: Canadian Real Estate Association Last observation: December 2022
Higher interest rates have also affected spending on big-ticket items that people
often buy on credit, such as furniture and appliances.
You can really see the decline in consumption in these interest-rate-sensitive
areas, but higher borrowing costs are starting to affect spending more broadly as
well. Consumption growth looks to have weakened substantially in the second
half of 2022 (Chart 3). Some of this slowdown reflects the waning boost from the
reopening, but higher interest rates have contributed.
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Chart 3: Consumption is easing amid higher rates
Goods and services consumption, growth over 2022H1 and 2022H2, annualized data
%
9
6
3
0
-3
Goods consumption Services consumption, including NPISH
2022H1 2022H2
Note: 2022Q4 is forecast. NPISH means non-profit institution serving households.
Sources: Statistics Canada and Bank of Canada calculations and projections Last data plotted: 2022Q4
Demand and supply
With demand slowing, we are seeing early signs that demand and supply are
becoming less out of balance in our overheated economy.
The output gap provides an overall measure of the balance between demand
and supply. Through 2021, the economy recovered rapidly-the fastest recovery
on record-and supply disruptions continued. As a result, the economy moved
into excess demand in 2022, putting upward pressure on prices here in Canada.
But excess demand appears to have peaked and is beginning to ease (Chart 4).
Chart 4: The economy remains in excess demand
Output gap, January 2023 Bank of Canada Monetary Policy Report
2
0
-2
-4
-6
-8
2019 2020 2021 2022
Sources: Statistics Canada and Bank of Canada calculations Last data plotted: 2022Q4
- 7 -
This picture of excess demand in the economy is reflected in a wide range of
labour market indicators. The unemployment rate is near historical lows,
businesses continue to report widespread labour shortages, and the job vacancy
rate is elevated.2
Labour markets were already tight before the pandemic, but now the
unemployment rates for prime-age, young and older workers are all lower than
they were before the pandemic. The unemployment rate today is also lower in
every province than it was pre-pandemic. Quebec and British Columbia have the
lowest unemployment rates of all.
The tightness in the labour market looks to have peaked around the middle of
2022 and has eased modestly. Job vacancies have declined from that peak, and
the share of firms facing labour shortages has edged down. Moreover, job growth
has been slowing more in interest-rate-sensitive sectors like construction, and
this has contributed to a slowing in overall employment growth (Chart 5).
Chart 5: Employment growth has eased in sectors sensitive to interest rates
Difference in contribution to employment growth over 2022H2 relative to 2022H1
Percentage points
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
Sensitive Moderately sensitive Not sensitive
Sources: Statistics Canada and Bank of Canada calculations Last observation: December 2022
Other factors also influence the labour market-declining fertility rates and an
aging population mean fewer young workers are entering the labour force and
more workers are retiring. In Canada, immigration was initially hampered by the
pandemic, but it is now improving along with rising labour force participation of
be
women. We'll watching a broad set of indicators to gauge the balance in the
labour market and how it is adjusting to tighter monetary policy.
Inflation
With demand moderating both globally and here in Canada, inflation has
declined. Annual consumer price index (CPI) inflation eased to 6.3% in
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December from its peak of 8.1% in June. This is a welcome development, but
inflation is still too high.
So far, the decline in inflation mostly reflects lower prices for energy, particularly
for gasoline. Improved global supply chains are also helping. Supply bottlenecks
and backlogs lasted far longer than we expected, but they are finally resolving
Global shipping costs have come down, which is filtering through to
(Chart 6).
lower prices for imported goods.
Chart 6: Inflationary pressures from supply bottlenecks are easing
GSCPI and PMI: Manufacturing suppliers' delivery times, monthly data
Index
Index
8 10
6 20
4 30
2 40
0 50
-2 60
2017 2018 2019 2020 2021 2022 2023
GSCPI (left scale) United States (right scale) Euro area (right scale)
China (right scale) Canada (right scale)
Note: The Global Supply Chain Pressure Index (GSCPI) provides a comprehensive summary of potential supply chain disruptions that
controls for demand-side factors. The Purchasing Managers' Index (PMI) is a diffusion index of business conditions. For suppliers'
delivery times, an inverted index is used to show that a reading less than (greater than) 50 indicates an increase (decrease) in delivery
times compared with the previous month.
Sources: S&P Global via Haver Analytics and Federal Reserve Bank of New York Last observation: December 2022
Inflation at home is also showing signs of easing, though prices for food and
many services continue to increase much too quickly. The cooling we do see in
inflation is in the same areas where we see higher interest rates slowing
demand.
Nationally, house prices are down 13% from their peak in February 2022. Here in
Québec, both the run-up and the decline in house prices have been more
modest-house prices have declined 2.5% since peaking in May.
Lower demand, better supply chains and lower shipping costs have brought
down durable goods inflation for three months in a row. Prices for household
appliances rose at a pace of just 2.8% in December, down from a 7.4% increase
the month before. Overall, durable goods price inflation has fallen from 7.9% at
its peak to 4.7% in December. And on a timelier three-month basis, these prices
were down 3.5% in December.
- 9 -
More broadly, we can also see that momentum in inflation has slowed. To see
the underlying trends in inflation, we look at measures of core inflation that
exclude the most volatile components of the CPI. Our preferred measures of core
inflation have been stuck at about 5%. But timelier three-month rates have come
down below 5%. That suggests core inflation will start to decline in the months
ahead.
Inflation expectations
That brings me to inflation expectations. With inflation still high, most
respondents to consumer and business surveys continue to expect that CPI
inflation will be well above 2% over the next two years. But our most recent
survey suggests fewer businesses now think high inflation will persist
(Chart 7).
A lot of uncertainty remains-the distribution of expectations is far wider than it
we're on the right track.
was before the pandemic. But
Chart 7: Firms' inflation expectations have shifted lower
Share of firms responding to the Business Outlook Survey with 2-year inflation expectations
in each range, quarterly data
%
40
35
30
25
20
15
10
5
0
≤1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 >8
Expected rate of inflation (%)
2022Q2 2022Q4
Note: The estimates are based on firms' responses to the Business Outlook Survey (BOS) question, "Over the next two years,
what do you expect the annual rate of inflation to be, based on the consumer price index?" Buckets exclude the lower
bound and include the upper bound.
Sources: Bank of Canada and Bank of Canada calculations
Last observation: 2022Q4
Looking ahead
What comes next? At the end of January, we said that we expect to pause rate
hikes while we assess the impacts of the substantial monetary policy tightening
already undertaken. This is a conditional pause-it is conditional on economic
developments evolving broadly in line with the outlook published in January.
we don't
As I have explained, the transmission mechanism takes time-typically
That's
see the full effects of changes in our overnight rate for 18 to 24 months.
shouldn't keep raising
why policy needs to be forward looking. In other words, we
rates until inflation is back to 2%. Instead, we need to pause rate hikes before we
slow the economy and inflation too much. And that is what we are doing now.
Our assessment that it is time to pause is based on what we have seen so far
and on our forecast for economic growth and inflation. We will be assessing
economic developments relative to this forecast. If new evidence begins to
accumulate that inflation is not declining in line with our forecast, we are
prepared to raise our policy rate further. But if new data are broadly in line with
won't need to raise
our forecast and inflation comes down as predicted, then we
rates further.
We expect economic growth to be close to zero for the next three quarters. With
growth in demand stalled, supply will catch up and the economy will move from
excess demand to modest excess supply. This will relieve inflationary pressures.
We have already seen inflation in goods prices begin to fall, and we expect this
to continue in the months ahead. But inflation in services prices will likely take
longer to recede, partly because of high labour costs (Chart 8). There is more
uncertainty about this slowing in services price inflation.
Chart 8: Near-term inflation is declining for some goods but will likely
remain high for services
%
Year-over-year percentage change, monthly data
6
4
2
0
Start of forecast
(January 2023)
-2
2017 2018 2019 2020 2021 2022 2023
Goods excluding energy and food in stores Services excluding shelter
Sources: Statistics Canada and Bank of Canada calculations, estimates and projections Last data plotted: June 2023
Wage growth is currently running between 4% and 5% and appears to have
plateaued within that range (Chart 9). With our survey of businesses also
suggesting that inflation expectations are edging back, the risk of a wage-price
spiral has diminished. Still, wage growth in that range is not consistent with
getting inflation back to the 2% target unless productivity growth is surprisingly
strong. We will be watching productivity, labour costs and services price inflation
closely.
Chart 9: Wage growth is around 4% to 5%
Wage growth measures, year-over-year percentage change, monthly data
%
12
10
8
6
4
2
0
-2
2017 2018 2019 2020 2021 2022 2023
LFS, variable-weight measure LFS, fixed-weight measure
SEPH, variable-weight measure SEPH, fixed-weight measure
Note: LFS is the Labour Force Survey; SEPH is the Survey of Employment, Payrolls and Hours; The LFS fixed-weight measure is constructed
using 2019 employment weights and is based on data released prior to January 30, 2023.
Sources: Statistics Canada and Bank of Canada calculations Last observations: SEPH, November 2022; LFS, December 2022
We will also be watching to see if price-setting behaviour by businesses is
normalizing. When inflation is low and stable, the competitive system works
effectively. But that wasn't happening last year when the economy overheated
and inflation increased. With inflation expectations elevated and the economy in
excess demand, businesses were raising their prices more frequently and by
more than usual. More recently, businesses have told us that they expect their
pricing behaviour will return to normal. We have already seen the distribution of
price changes start to normalize, but we are still a long way from normal.
(Chart 10).
Chart 10: Inflation among CPI components is normalizing but remains distorted
Three-month annualized price distributions
Density
0.10
0.05
0.00
-20 -10 0 10 20 30
February 2020 May 2022 December 2022
Note: CPI is the consumer price index.
Sources: Statistics Canada and Bank of Canada calculations Last observation: December 2022
In summary, recent developments have reinforced our confidence that inflation is
coming down. We now expect CPI inflation to fall to around 3% in the middle of
We've already seen
this year and reach the 2% target in 2024 (Chart 11). a
momentum shift in goods prices. For inflation to get back to 2%, supply needs to
catch up with demand and services price inflation needs to cool. Wage growth
will need to moderate alongside inflation expectations, and pricing behaviour
normalize. If those things don't happen, inflation won't
come back to our 2%
target, and additional monetary tightening will be required.
We will be watching inflation data especially carefully to see if it is coming in
broadly in line with our forecast.
Chart 11: Inflation is forecast to return to the 2% target in 2024
Year-over-year percentage change, quarterly data
%
8
6
4
2
Start of forecast (2023Q1)
0
-2
2017 2018 2019 2020 2021 2022 2023 2024
1%-3% inflation control range CPI inflation
Sources: Statistics Canada and Bank of Canada calculations, estimates and projections
Conclusion
It's time for me to conclude. I've given you a picture of how monetary policy
works-how our interest rate increases work their way through the economy to
slow borrowing, dampen demand and ultimately lower both imported and
We know that the monetary policy tightening we've
domestic inflation.
undertaken is hard on many Canadians. Unfortunately, there is no easy way to
Monetary policy doesn't work as quickly or painlessly as
restore price stability.
everyone would like, but it works. And it will be worth it when Canadians can
once again count on low, stable and predictable inflation.
As always, we will be clear and transparent. I want Canadians to understand
what we're doing to fight inflation, how it works
and why it matters. I also want to
be clear about the uncertainties we face-the lingering effects of a global
pandemic, a war in Europe and broader geopolitical tensions.
There are risks to our projection. The biggest is that global energy prices could
We're also concerned that
increase, pushing inflation up around the world.
inflation expectations could remain elevated and increases in labour costs could
persist. If these upside risks materialize, we are prepared to raise interest rates
further to return inflation to the 2% target.
There are downside risks to our projection as well. Global growth could slow
more sharply than we expect, and financial vulnerabilities could amplify the
slowdown. Canadian households could pull back more than we expect as they
adjust to higher interest rates.
Overall, we view the risks around our inflation forecast as balanced. But with
inflation still well above our target, we continue to be more concerned about the
upside risks.
Inflation will fall in the months ahead, and we will be watching for further
evidence that demand and supply are rebalancing so that inflation heads all the
way back to the 2% target. We will continue to explain what we are seeing, what
we are doing and what Canadians can expect from us. We are resolute in our
commitment to restoring price stability for Canadians.
Thank you.