Tiff Macklem: Putting the resolute in resolutions - looking ahead to
lower inflation
Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the Business Council
of British Columbia, Vancouver, British Columbia, 12 December 2022.
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Introduction
Good afternoon. It's a great pleasure to be here. I want to thank the Business Council of
British Columbia for inviting me to speak today. I am particularly looking forward to
sitting down after my remarks and discussing the issues facing the province, the
challenges confronting the Canadian economy and the questions being put to the Bank
of Canada.
This is my final speech of 2022-and what a year it has been. A year-end speech often
looks back at what's happened and ahead to what's next. This one fits that mould.
What's different is that nothing about our recent economic experience fits the mould of
the last 30 years. The pandemic brought on-again, off-again shutdowns to the global
economy, dramatic shifts in the goods and services consumers wanted to buy, and a
myriad of hurdles for producers to supply them. All of this, combined with Russia's
horrific aggression in Ukraine, has brought sharply higher inflation and rapidly rising
interest rates.
Last week, we raised our overnight policy rate by 50 basis points to 4.25%, our seventh
consecutive rate increase since we began raising interest rates in March to fight
inflation. Deputy Governor Sharon Kozicki explained our decision in a speech last
Thursday. Today, I'd like to provide a broader perspective. I want to reflect on what
we've learned in 2022, discuss what could lie ahead and explain what we're focused on
at the Bank of Canada. It's a bit early for New Year's resolutions, but I already know
what ours is: Restore price stability.
We are resolute in our commitment to return inflation to the 2% target. Higher interest
rates are working to rebalance the economy. Domestic demand is slowing, and we
expect growth in gross domestic product will be close to zero through to the middle of
next year as the economy adjusts to higher interest rates. This will relieve domestic
price pressures, and inflation will come down. The adjustment will not be easy, but
restoring price stability is the most important thing we can do to improve the economic
and financial well-being of Canadians.
Looking back
A year ago, the economy was getting closer to capacity, but we were still coping with
new waves of the COVID-19 virus. Unemployment was a percentage point higher than
it is now. Supply chain disruptions combined with strong global demand for goods had
driven total consumer price index inflation up to 4.7%, but services price inflation
remained relatively low, and inflation was not broad-based. At that time, we expected
supply issues to gradually resolve and inflation to come down to close to our 2% target
by the end of 2022.
At about 7% today, inflation is a long way from what we had expected. What
happened? Three things surprised us. First, supply problems-both global and
domesticproved to be more persistent and pervasive than we had anticipated. This put upward
pressure on many prices. Second, Russia invaded Ukraine, sending prices for energy
and agricultural goods sharply higher. And third, once we got through the Omicron
wave early in the new year, the economy fully reopened, and consumers wanted to
catch up quickly on what they had missed for two years. But businesses could not keep
up with demand, and this put significant upward pressure on services prices.
With the information we had a year ago, it was impossible to foresee all these
developments. But it's too convenient to write off the high inflation of 2022 as just bad
luck. We need to reflect on what we learned.
I see three lessons.
First, restoring supply is harder than restoring demand. Hyper-efficient global supply
chains are a marvel of system design, transportation and logistics. And when they are
working, we take them for granted. But the pandemic reminded us that a chain is only
as strong as its weakest link. With the waves of the virus hitting different parts of the
world at different times, supply and demand could not recover in tandem. Moreover, the
large shift in demand during the pandemic toward goods and away from services put
even more pressure on clogged supply chains. Businesses couldn't meet customer
demand, and prices of goods rose sharply. With hindsight, the monetary and fiscal
policy tools that were used to stabilize the economy worked effectively to support
demand during the pandemic, but we underestimated the supply challenges.
Second, averages can obscure inflationary pressures. We need a more granular
understanding of the balance between demand and supply when the forces driving
demand diverge dramatically across sectors. Public health measures restricted the
demand for services. At the same time, other parts of the economy were experiencing
excess demand as consumers bought goods to replace the services they couldn't get.
But the inflationary impact of excess demand for goods was larger than the
disinflationary forces in close-contact services. As a result, our inflation models that
focus on the average or aggregate imbalance between demand and supply in the
economy had a hard time predicting the rise in inflation.
Third, supply disruptions are more inflationary when the economy is overheated. For
the last 30 years, supply shocks-typically energy-have tended to have a temporary
effect on inflation. A run-up in oil prices, for example, would boost inflation for a year or
so, but oil prices would typically plateau or reverse, and inflation would come back
down all by itself. Since it takes more than a year for the full effect of monetary policy to
work through the economy, central banks have tended to look through the direct impact
of supply disruptions on inflation. That means we don't respond by raising interest rates.
This year, the inflation response was different. As I've already mentioned, we were
faced with a series of negative supply shocks just as the economy was reopening. And
the effects of these supply shocks on prices and inflation was faster and more
pronounced than usual. Businesses, flush with customers, weren't worried about raising
their prices. So they passed on the higher input costs more quickly to final goods prices.
And customers, eager to finally buy what they wanted, paid the higher prices. As a
result, the impact on inflation of the energy and agricultural price shocks was faster,
larger and more widespread than our models suggested.
In sum, since we started inflation targeting in the early 1990s, we have not been hit by
large negative supply shocks at the same time as our economy was overheating. The
lesson from 2022 is that even if long-term inflation expectations are well anchored,
when the economy is in excess demand, businesses raise their prices more quickly and
by more when their costs increase.
All three lessons are linked, and we have taken them to heart. You don't get 8%
inflation because one thing went wrong. Our experience in 2022 is that surprises can
combine and interact with each other, resulting in outsized effects on inflation.
I'd be pleased to talk more about these lessons and how we are adapting in our
discussion, but now I want to look ahead to 2023.
Looking ahead
Our top priority is getting inflation back to the 2% target. By raising interest rates, we
are trying to dampen demand so supply can catch up. That will bring the overheated
economy back into balance, and inflation will come down. Interest rate increases have
begun to work, but they will take time to feed through the economy.
We have increased interest rates rapidly both because inflation rose quickly and
because the economy was overheating. Once we started to see the momentum in
domestic demand, we moved forcefully. Since March, we have raised our policy rate by
four percentage points. Increasing rates rapidly to rebalance demand and supply and to
keep long-run inflation expectations anchored to our target is our best chance of
restoring price stability without a severe economic contraction.
At last week's decision to raise the policy rate by 50 basis points we indicated that,
looking ahead, we will be considering whether there is a need to increase the policy
rate further. This means that decisions to raise the rate or to pause and assess the
impact of past rate increases will depend on incoming data and our judgments about
the outlook for inflation.
We are trying to balance the risks of over- and under-tightening monetary policy. If we
raise rates too much, we could drive the economy into an unnecessarily painful
recession and undershoot the inflation target. If we don't raise them enough, inflation
will remain elevated, and households and business will come to expect persistently high
inflation. With inflation running well above target, this is the greater risk. If high inflation
sticks, much higher interest rates will be required to restore price stability, and the
economy will have to slow even more sharply.
We are watching very closely to see how the economy is responding to higher interest
rates. We are looking at an expanded range of labour market indicators to assess the
balance in the job market and the impacts on workers. We're watching to see how
supply chains are resolving and how businesses are passing on changes in costs to
consumers. We're also keeping an eye on measures of core inflation to gauge
underlying inflationary pressures. And finally, we're closely watching inflation
expectations because keeping them well anchored is critical to restoring price stability.
Looking beyond tomorrow
Over the two decades up to 2020, a number of disinflationary forces helped keep
inflation low. A relatively stable global political landscape combined with a broad
consensus in favour of free markets and international trade encouraged investment and
supported productivity. Technological advancements also lifted global productivity,
shrank distances and lowered costs. The entry into the global trade system of vast new
labour markets in China and Eastern Europe pushed down the prices of many traded
goods. Global supply chains grew rapidly, minimizing costs by linking the global
economy through heightened specialization and trade. These supply developments all
fostered a period of solid growth, low inflation and low interest rates.
But these forces are now shifting. The failure to adequately share the benefits of growth
has fuelled populism that is causing countries to turn inward. Support for globalization is
stalling or even reversing, and productivity growth is trending down. And as the growth
in the working-age population slows and businesses find it harder to hire workers, there
could be persistent upward pressure on wages. If higher wage costs are not matched
by improvements in productivity, the costs of production will increase.
Almost three years of the pandemic and the invasion of Ukraine by Russia have also
highlighted some of the vulnerabilities of interconnected trade. The pandemic made
clear that relying too much on highly specialized supply chains can have downsides.
And Russia's weaponization of its natural gas supply has underscored the risks of
assuming all countries share the same interests in peace and prosperity. Rising
geopolitical tensions, more broadly, have underscored the fragility of some business
relationships.
In the future, it seems likely that supply chains will be shorter, more diversified and
more resilient. Trade will likely narrow to more trusted partners. These changes will
increase resilience but at the cost of efficiency. And through this adjustment, production
costs could rise, increasing price pressures.
Over the long term, it seems likely that we won't have the same disinflationary forces
that we've had for the past 30 years. These potential developments could make it
harder to bring inflation back to the 2% target and keep it there. But how much harder is
very difficult to say.
These are fundamental uncertainties we'll need to confront in the years ahead. But by
constantly focusing on achieving the 2% inflation target, our monetary policy framework
is well designed to address uncertainty and adapt to new developments. If the
inflationary forces going forward are stronger than we expect, we will start to see
inflation coming in above our forecasts. And we will adjust our policy settings to achieve
the 2% target. If, on the other hand, disinflationary forces return and inflation starts to
come in below our forecasts, again we will adjust to hit the target. Assessing the
impacts of shifting forces will be difficult in the moment, but we can be confident that our
framework is designed for all seasons.
Conclusion
Let me conclude. I've spent most of my time talking about hard lessons and difficult
decisions. But I want to end on a note of optimism.
While global forces are shifting, the future will be a lot better than the last three years.
Aging demographics, rising geopolitical tensions and climate change all mean global
economies could face more supply shocks than in the past. But even if volatility does
not return to the pre-pandemic level, we can expect it will be much lower than what we
have all endured these past three years.
I also want to stress that the future is not destiny-what we do now will influence how we
are positioned when the future arrives. The more we invest in increasing supply through
trade, automation, innovation, training and immigration, the faster the Canadian
economy can grow without creating inflationary pressures. Canada thrives in a world of
open trade and investment flows, and its market access is among the best in the world.
We need to protect this and deepen our trading relationships. Businesses need to look
to the future and leverage automation to free up workers for higher-value roles and
provide training to prepare them for these opportunities. Governments need to foster
innovation and ensure Canada remains a country of choice for new immigrants.
The Bank of Canada's job is to ensure price stability. Low, stable and predictable
inflation is fundamental to a well-functioning and growing economy that delivers
prosperity for its citizens.
People ask me why we need to be so aggressive about raising interest rates to combat
inflation. They also ask me why we need to get inflation all the way back to 2%.
It's simple even though it can be difficult. The longer inflation remains high, and the
higher it is, the harder it is for Canadians to plan their spending and savings. Inflation
erodes the value of money. It distorts and confuses the information and incentives that
consumers, businesses, entrepreneurs, savers and investors rely on to make their
economic decisions. It feeds frustration, social tensions and a sense of unfairness.
We want to restore price stability in the best way possible for Canadian workers and
businesses. We know the adjustment is difficult. But it will be worth it. Our monetary
policy is working, and once we all get through this adjustment, our economy can grow
healthily with low inflation. That's what lies ahead if we follow through.
Our resolution is simple, and our resolve is absolute. We will restore price stability for all
Canadians.
Thank you.
I would like to thank Don Coletti and Césaire Meh for their help in preparing this
speech.