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Inflation is coming down; interest rates aren't. Here's why

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Peter Dungan

Despite a few speedbumps, Canada has remained on a steady path towards tackling inflation, but don’t expect interest rates to return to 2021 levels anytime soon.

That’s according to Rotman associate professor emeritus of economics Peter Dungan, who understands why some Canadians may be skeptical of the Bank of Canada’s efforts of late, as inflation remains a persistent problem, despite prior characterizations of being only temporary or “transitory.” That’s because most of the factors that continue to drive inflation today were impossible to predict when prices began to rise in mid-2021.

“It’s still temporary,” says Dungan, “It’s just a little less temporary than before the invasion of Ukraine occurred.” He explains that, at the time, few could have predicted an all-out war between Russia, one of the world’s largest oil and gas producers, and Ukraine, one of its biggest grain producers. That conflict, he says, is one of three primary factors that threw economic forecasts off course. 

The impacts of the other two — namely supply chain challenges that began as pandemic restrictions subsided, and the significant injection of cash that came in the form of economic stimulus programs — would have long ago subsided if not for the war, which has kept food and energy prices high.

“Put those three together, and this is one where I would say it would have been almost impossible to see the worst of it coming, and difficult to see even part of it coming,” he says of the inflation felt since the conflict in Europe began.

The latest consumer price index reading pegged year-over-year inflation in Canada at 3.3 per cent in July 2023, a dramatic improvement from the 8.1 per cent peak recorded June 2022, but still above the Bank’s target range of one to three per cent.    

There is one other factor that sparked this recent bout of global inflation, and it’s the only one in which Dungan believes central banks may have been at least somewhat culpable. He explains that policymakers at the Bank of Canada, American Federal Reserve, and other global counterparts knew pandemic-era interest rates were unsustainably low.

At the start of the pandemic the Bank of Canada dropped what would historically be considered a low interest rate of 1.75 per cent down to just .25 per cent, resulting in mortgage rates below two per cent. The Bank didn’t bring rates back up from that extreme low until March of 2022, and Dungan says that in hindsight it probably should have acted sooner.

 “If you read the articles from late 2021, what you see from the Fed and the Bank of Canada is, ‘yes, we’ll have to start raising interest rates, but we don’t want to upset the recovery,’” Dungan says. “However, once the economy recovered — however long that took — interest rates had to go back up.”

Dungan admits the June 2023 rate hike, which brought policy interest rates to 4.75 per cent from 4.5 per cent caught him – and other economists – off guard, though it is likely a rational move within a broader context.

In late 2007, the Bank posted a policy rate of 4.5 per cent, but as the financial crisis took hold, it continually lowered them until reaching a low of 0.25 per cent in early 2009. As the economy recovered, however, rates never resumed their prior position, lingering between 0.5 per cent and one per cent for most of the 2010s, until gradually increasing to 1.75 per cent in early 2020. That, according to Dungan, left the bank little room to cut rates further at the start of the pandemic, a mistake they likely aren’t keen to repeat.

“[The policy rate] is not going back to two — it’s just not — unless we have a serious recession or emergency,” he says. “Those numbers are gone for good, except as a way to stimulate the economy, so you might go to 4.5 per cent, but it will probably be north of 4 per cent until the next serious emergency, when centra banks need to cut policy rates drastically to help the economy.”

In other words, the Bank of Canada likely raised its rates in June and July to give itself more room to lower them in the future. As a result, Dungan says those anticipating this period of inflation to end with rates at the rock-bottom lows seen during the pandemic need to recalibrate their expectations.  

Policy rates lower than four per cent would likely only happen in tandem with another major global disruption, like a pandemic, war, or other significant financial crisis. “If rates ever do get back to two per cent, there’s more to worry about,” he says. “That means something really bad would have happened.”

Dungan feels confident that the July policy rate hike will probably be the last for some time (despite the slight rise in the CPI headline rate).  He expects that rate to persist for perhaps as much as 12 months, before a gradual decline to something in the three to 3.5 per cent range, where it will remain long term. That is, of course, barring any more unforeseen economic shocks.

“As soon as a blockade of Taiwan begins, throw that all out the window,” he says, half-jokingly. “But if nothing like that happens — no major pandemics of one kind or another — it’s looking pretty good, quite frankly, and Canada is looking the best out of everybody.”

Dungan explains that compared to similar economies, Canada’s inflation rate is lower, its unemployment rate is higher — which is good for the economy, but still relatively low by historical standards, which is good for workers — and there is reason to be believe the worst of this turbulent economic period is behind us.

“Most people were saying it would take at least a minor recession to get us out of this inflation episode; now it’s not so clear,” he says. “The economy won’t exactly be booming for the next few quarters because it’s still absorbing the higher interest rate, but that will be enough to push us into the target band, and we can move on from there.”

Peter Dungan is an associate professor emeritus of economic analysis and policy at the Rotman School of Management, with cross-appointments at the department of economics and the Munk School of Global Affairs and Public Policy.