The Decibel - Why is it so important to get inflation down to two per cent?

Episode Date: July 19, 2023

We’re all familiar with the cycle now: Inflation is too high, so central banks keep raising interest rates. The hope is to get inflation back down to 2 per cent. But why 2? If we accept that things are going to keep getting more expensive, what difference does it make if it’s 2 or 3 per cent? Or 2.8?Report on Business reporter Mark Rendell explains why we’re aiming for 2-per-cent inflation, whether that target will change and what he learned from a recent interview with Tiff Macklem, Governor of the Bank of Canada.Questions? Comments? Ideas? E-mail us at [e-mail]

Let's cast our minds back to a simpler time. July 2019. No COVID. No war in Ukraine. And inflation at 2%. A lot has changed since then. Inflation shot up and the cost of living increased. And in response, Canada's central bank tried to slow down inflation by hiking interest rates,

which ended up making life even more expensive for some of us. The interest rate now sits at 5%, the highest it's been since 2001. The reason for these aggressive interest rate hikes is to try to get inflation back down to 2%. But why is 2% the magic number? Report on Business Reporter Mark Rendell is on the show to explain. I'm Maina Karaman-Wilms, and this is The Decibel from The Globe and Mail. Mark, thank you so much for joining me again. Thanks so much for having me today. I have to say, we have this joke on the team where we're always talking about different business stories,

and we're like, oh, is this an inflation episode? Is this an inflation episode? Because it seems like a lot of the news these days, not even just business, a lot of the news these days is about inflation. But I can say with certainty, this one is definitely about inflation. This is an inflation episode. It is. It is. I mean, we have the inflation numbers today. We had a Bank of Canada rate decision last week. So it's a good time to be talking about inflation. So let's start by talking about the new numbers that we got this week. The Consumer Price Index was released on Tuesday. It clocked in at 2.8%. So Mark, as the reporter who covers Bank of Canada for the Globe of Mail, what was the first thought that popped into your head when you saw this number? Well, it's a really symbolic moment because being under 3% puts the Consumer Price Index

inflation back within the Bank of Canada's target range. Everybody knows about the 2% target. That's what they speak about all the time. But they actually target a range between 1% and 3%. So it's definitely not mission accomplished for the Bank of Canada. They're still trying to get down to that 2%. And there is a likelihood that we're going to see inflation tick back up above 3% in the next couple of months. But the first thing that popped in my mind was like, whoa, we're back. It's been a rollercoaster ride. We went way, way up. We're now a long way down. And so I think a big symbolic moment today. Yeah. And you said like rollercoaster ride, of course, like the high was above 8%,

right, at one point. So down at 2.8 seems pretty reasonable. Is this what people expected to see, kind of a 2.8 number here? It's lower than people expected. I think the consensus forecast on Bay Street was around 3%. The biggest thing in the CPI data today was gasoline prices. I think gasoline prices were 22% lower than they were last year. So you had a big- 22%. 22% since last June. So last June, when you had this peak, and again, it was both the Russia's invasion of Ukraine, you also had demand for global oil coming out of China, which had, you know, by that point taken a lot of the COVID-19 restrictions off. So you had this big

surge in demand for oil last year, and that's leveled off. So the biggest thing that's been dragging it down is the oil price. Now, you had some other kind of idiosyncratic things. Cell phone bills dropped pretty dramatically. Not my cell phone bill. I don't know whose cell phone bill is dropping, but okay. That's often what you'll see when you crack open the stats can numbers. You're like, oh, is that true? I don't think I saw that. But anyway, there's a number of idiosyncratic factors. But the gasoline thing is the big thing. And that's one reason that, you know, you may see inflation tick up slightly. Most people don't expect to see a huge spike in inflation, but it's a lot of people think that it will probably take up again a little bit, slightly above the 3% in the coming months, because those year-over-year gas price comparisons aren't going to be quite so flattering.

Okay. All right. So that's where inflation stands. Before we dig into this a bit more, Mark, I think it might be helpful for people if we just set up some of the other key indicators that the Bank of Canada watches when we're looking at Canada's economy. So I'm thinking about things like GDP, unemployment, and the interest rate. So can you just kind of give us a rundown on how those things are doing these days?

Yeah, yeah. So I'll mention just before we hop off inflation, one key point, which is the Bank of Canada doesn't just look at that 2.8 number. They're looking at what they call core measures, which are basically statistical numbers that try to strip out like really volatile things. They try to strip out food, gasoline. So this is like the core things, essentially. Yeah, they have a whole range of different measures.

And those core measures are still quite a bit above 3%. So some of the core measures that they track most closely are in the kind of 3.5 to 4%. And those, the Bank of Canada thinks do a better job of capturing like, what is the underlying inflation pressures? So in terms of the other things they look at, the economy has been a lot stronger than they expected. So in January, the Bank of Canada actually paused rate hikes. They said, we think we've done enough, we raised rates a bunch, we're going to sit and watch and see what happens. And they expected things to slow over the first half of this year. A lot of people thought there'd be a recession by now. Those indicators haven't been

as weak as many people expected. Unemployment is still quite low. It's been ticking up a little bit, but Canadian employers are still creating a lot of jobs. GDP completely exceeded expectations in the first quarter of the year. It is slowing down. The signs from April and May suggest GDP is coming in a little bit, GDP growth, I should say, but still stronger than expected. And then the big thing that's, I think, surprised a lot of people is consumers keep spending a lot of money. But it is this kind of bizarre thing that the Bank of Canada is trying to wrap its head around is why is the economy stronger than we expected? Why aren't people pulling back on spending as much? And the fact that they're not is one of the reasons that they ended their pause in June. They hiked again last week. I think that caught

everybody. At least the June hike caught a lot of people by surprise. Nobody really thought we'd be still hiking at this point, but there you are. Okay. So the Bank of Canada has been hiking rates for nearly a year and a half now. From the point of view of the Bank of Canada, have those rate hikes been effective? They do think they're working. I mean, clearly when you look at the headline inflation number, inflation is coming down a lot, but the rate hikes been effective? They do think they're working. I mean, clearly, when you look at the headline inflation number, inflation is coming down a lot. But the rate hikes are working less powerfully than I think the bank expected. So I interviewed Tiff Macklin, the governor of the Bank of Canada, last week after the rate increase and asked him why the rate hikes hadn't been as powerful as he expected. And he gave a couple of interesting answers. For one thing, population growth has been very, very strong.

There's been a real rebound in immigration levels. That's adding a lot of demand to the economy. That's also adding a lot of supply to labor markets. So remember, one of the reasons inflation is going up is because labor markets are really tight, wages are rising quickly, and bringing more workers in helps deal with those labor supply issues. But it also brings a whole bunch of consumers into the market that, you know, buy goods, rent apartments, buy houses, all of that. There's something that the bank

account calls excess savings, which I don't think you and I probably think too much about having excess savings. Sounds wonderful, yeah. I know, exactly. But the idea is during the pandemic, people saved more than they would usually. And so people are still working through those, again, Bank of Canada's term, but working through those excess savings.

And that might be one of the reasons that rate hikes aren't as powerful. Finally, I'll just mention, labor markets are really tight. There's huge demand for workers. And when a lot of people are employed and when wages are rising, that means a lot of people are spending money. Okay. So how does the Bank of Canada think about how Canadians are coping with this? Yeah, it's been a real double whammy for a lot of people because

you have inflation, you have prices going up very rapidly and prices for things for a lot of people because you have inflation, you have prices going up very rapidly and prices for things that a lot of people need on a daily basis. Prices for food is crazy. And then you add on top of that debt payments, which have gone up, mortgage payments, which have gone up as the Bank of Canada has raised interest rates. But surprisingly, in the Bank of Canada's most recent, what they call their monetary policy report, which is their kind of quarterly assessment of the economy, they had a special box where they talked about household finances. And they said, by and large, people seem to still be relatively healthy from a financial perspective. Default rates on mortgages are very, very low still, even for variable rate mortgages.

But you are seeing signs that people are being stressed. Credit card usage is way up, although delinquency rates in general on most credit products are still pretty low. What is a delinquency rate? That's how many people can't pay or are having trouble paying. Although that's low, you're starting to see people who were 60 days late on a payment. The proportion of them who are now 90 days late on a payment has gone up massively. And so their assessment is overall things are relatively healthy, but there's big pockets that are worth watching and keeping an eye on. So the economy is still pretty strong, it sounds like, Mark.

We haven't slipped into a recession because there was talk about that potentially, right? Inflation is dropping. People are generally surviving, maybe not thriving, but people are getting by. Things seem good. Why is the Bank of Canada acting like things aren't? Because it's continuing to increase these interest rates. It's because they are hell-bent on getting back to 2%. And that can seem a little bit confusing when you're so close to 2%, 2.8% today.

Why keep raising interest rates? Why try to squeeze that last 0.8% of inflation out of the economy? Now, it's partially because that's what they're told to do. They have a mandate to hit 2%. They do have this flexible band around that, which they can use. But they believe pretty strongly that if you want to be around 2%, if you want to be within that band over time, you got to aim for that 2% right in the middle. There are signs that core inflation is still pretty strong. And the Bank of Canada's big fear

is that the rate of inflation is going to get stuck above 3%. And in their most recent forecast, which they put out last week, they actually extended the timeline to get back to 2%. They used to say, by the end of 2024, we'll be back at 2%. They're now saying, it's actually going to be around 3% for the next year. Then by the middle of 2025, it'll get back to 2%. So as much as things are moving in the right direction on inflation, there's certain indicators that are stalled.

And all that economic strength, remember, we got to remember that good is bad, bad is good. Topsy-turvy world here. Topsy-turvy world for the Bank of Canada. And so they're looking at all of these indicators of economic strength and saying, oh, that's not good news for our fight to control inflation. The reason good is bad, bad is good, everything is topsy-turvy for the Bank of Canada is because, again, they're trying to slow down the economy. They're trying to make people spend less because the idea there is that you slow down or you

reduce the pressures on upward prices. And you got to remember, the Bank of Canada's number one goal, the thing that's their North Star, is trying to stabilize the purchasing power of the dollar. And the way they think about it is they're willing to inflict what they think is going to be short-term pain. They're willing to squeeze household finances. They're willing and are actually trying, believe it or not, to drive up unemployment. They're trying to weaken the labor market because they think the short-term pain of these things will be outweighed by the longer-term gain, which is to stabilize the purchasing power of the Canadian dollar and slow down

the pace of inflation. We'll be right back. Let's talk more about this 2% target because we've been using this for a while now. We hear about it a lot when we're talking about Bank of Canada these days. But Mark, how did we get to this idea that 2% is the magic number when it comes to inflation? So central banks, by the 90s, they were trying to basically figure out a new model for doing monetary policy. Back earlier in the 20th century, the value of a dollar was tied to gold. Later on, it became tied to a US dollar, which was tied to gold. And in the 20th century, the value of a dollar was tied to gold. Later on, it became tied to a US dollar, which was tied to gold. And in the 70s, that kind of fell apart. And central banks were

looking around for, okay, how do we anchor the purchasing power of our money? They tried a bunch of things in the 70s, didn't work terribly well through the 80s. You had this big inflation spike. By the 90s, central bank was like, hmm, why don't we try targeting inflation itself? Why don't we tell everybody, here's a number that we're going to target? And New Zealand came out and said this first. In 1991, Canada followed. They initially said, we're going to slowly bring inflation down year over year. So we're going to target 3% inflation in 1992. The next year, we're going to target 2.5% inflation. And by 1995, we're going to be at 2% inflation. 2% kind of became the commonly accepted thing around the

world that inflation targeting central banks would try to hit. Yeah. I still wonder though, like why 2% specifically? Like why couldn't we aim for 0% inflation as the goal? Yeah. So they actually, in 2011, they thought about lowering it to the target to 1%. In 2016, they thought about raising the target to 3%. Both times they rejected it. 2% is kind of seen as a bit of a sweet spot for inflation. It's very hard to hit absolute price stability, to basically hit zero inflation. And it's not something that economists actually want to aim for.

And there's a couple of reasons for that. Reason number one is that central banks, when you hit a recession, when things in the economy really go bad, the central bank wants to be able to cut interest rates in order to stimulate economic activity to help kind of bring the economy back out of that recession. And if you're targeting zero inflation, interest rates in general are going to be a bit lower, and there's going to be less wiggle room for a central bank to cut inflation. Economists also think a bit of inflation actually helps labor market adjustments, because people really don't like getting wage cuts. But having a little bit of inflation in the economy allows more productive workers to

essentially keep pace with inflation. Less productive workers are going to see their wages essentially get inflated away without actually seeing a wage cut. So there's a reason they don't want absolutely no inflation. But then the question is, why not 3% inflation? Why not 4% inflation? Why is that 2% target ideal? And that comes down to how people think about inflation. When inflation is above 3% or 4%, people start to notice it. And the Bank of Canada basically doesn't want people to notice inflation. They don't want people to think about it. Because if you think about inflation, if you're a worker and you're thinking about inflation, you're more likely to go to ask your boss for a raise. If you're a business and you're thinking about inflation, you're more likely to say, huh, what are my competitors doing? I should go and raise prices.

So the more that inflation becomes salient in people's minds, that actually has a real impact on inflation itself. So a big part of monetary policy is psychology. A big part of monetary policy isn't just mechanically making it more or less expensive to borrow money. It's also about adjusting people's expectations about how much prices are going to change because that's going to affect price-setting behavior. It's going to affect wages. It's going to affect a whole range of things. Well, yeah. I mean, I'm always surprised when you talk about the stuff that emotion and people's perception of things actually influences in such a huge way, like what the inflation rate is. That always surprises me, but it's a huge part, it sounds like.

It is, because if you think what drives inflation, it's real decisions made by individuals and companies and households. So the thing with the 2% and why not higher, why not 3% is, and again, the Bank of Canada looked at this in 2016 and they said, there's some reason to go to a higher target, 3%. It would actually, again, give us more wiggle room to cut if we need to cut in the event of a recession. But it could potentially unanchor people's inflation expectations. What exactly does that mean? It means that they're worried that if you think I'm going to go from 2% to 3%, then why not next year go from 3% to 4%?

And why not the following year go from 3% to 4%? And why not the following year go from 4% to 5%? Right now we're at 2.8%, which is in that range, right, of the 1% to 3%. It's not right at 2%, but it's in the range. It can't be that different from 2%, right? Is it really worth putting people through this financial hardship and making it difficult for people and possibly driving up unemployment really for 0.8% of a difference? Is it worth it? Yeah. So from the Bank of Canada's perspective, the answer is yes, because they're very concerned about credibility. They told people they would hit 2%. They want to make sure that they do hit 2%. Why is credibility so important? It's because they're trying to anchor those

inflation expectations. Monetary policy is a trust game. It's about convincing people that you're going to do what you say you're going to do. There is a really interesting debate to be had right now, though, which is, one, is it the right target? Some people are having this debate. It's not really a mainstream debate yet, but there are certainly economists who are saying maybe it's time to rethink the target. But a bigger, perhaps more mainstream debate is why isn't the Bank of Canada using that flexibility of its 1% to 3% range to take a little bit more time to get inflation back

to target? I think the Bank of Canada's response would be, well, because those core measures are getting stuck above 3%. Just very lastly here, Mark, I think people generally kind of want to know when they're going to get some relief from these rising interest rates. So do we know anything about what the Bank of Canada has said about when it might actually start cutting rates? They are not thinking about cutting rates. They are more likely to raise rates again than cut rates. There is still a possibility that they may raise rates again in September.

So they left that open after the rate decision last week. They said quite explicitly, we are data dependent. If data comes in strong, we may have to raise rates again. And we're willing to do that. So if GDP numbers are strong, if unemployment is still low, those are indicators that might do that. If the core inflation measures are still strong, if inflation is ticking back up again next month,

they could very well hike rates again in September. Rate cuts are a long way away. Bay Street economists think probably sometime next year, you might start to see rate cuts. I'd be quite surprised to see any rate cuts before then. Bit of a downer note to end on, but it's good to get a reality check on this stuff, Mark. Thank you so much for being here today. It's great to be here. Thanks for having me. That's it for today. I'm Mainika Raman-Wells. Our summer producer is Nagin Nia. Our producers are Madeline White, Cheryl Sutherland, and Rachel Levy-McLaughlin.

David Crosby edits the show. Adrienne Chung is our senior producer. And Angela Pachenza is our executive editor. Thanks so much for listening, and I'll talk to you tomorrow.