Bank of Canada damned if it does, damned if it doesn’t

Hey there, time traveller!
This article was published 15/08/2023 (831 days ago), so information in it may no longer be current.

The Bank of Canada is in a catch-22: the higher it jacks up interest rates to fight inflation, the more it contributes to higher prices through rising mortgage costs.

The question is, do we really need another interest rate hike given that reality?

Inflation rose slightly to 3.3 per cent in July, up from 2.8 per cent in June, the latest data from Statistics Canada, released Tuesday, shows. The rise is mostly because gasoline prices didn’t fall as sharply as they did earlier this year.

The new inflation numbers also show mortgage interest costs continue to be the biggest driver of today’s consumer price index.

Mortgage interest costs jumped a staggering 31 per cent in July compared with the same month last year, another year-over-year record, Statistics Canada reported.

That’s not a great surprise. The Bank of Canada has been aggressively boosting interest rates over the past year to try to dampen employment, economic growth and ultimately price increases. That’s going to drive up mortgage costs.

However, the central bank has reached a point where it could be doing more harm than good as mortgage costs are now a significant source of inflation.

“The central bank has reached a point where it could be doing more harm than good as mortgage costs are now a significant source of inflation.”

Inflation in July, excluding mortgage interest costs, was 2.4 per cent, well within the central bank’s target range of one to three per cent. Even its “core” inflation measurements (it uses several, each with complicated economic explanations) have been falling in recent months: CPI-common, down to 4.8 per cent from 5.7 per cent in April; CPI-median, down to 3.7 per cent from 4.1 per cent in April; and CPI-trim down to 3.6 per cent from 4.2 per cent in April. That’s all good news.

Prices are also rising at a slower pace in five of Statistics Canada’s eight CPI categories, including two in which prices have fallen (“transportation” and “household operations, furnishings and equipment”).

There’s bad news, too, especially for low-income Canadians. Food prices are still rising by 7.8 per cent (down slightly from 8.3 per cent in June) and grocery prices were up 8.5 per cent in July (slightly better than 9.1 per cent the previous month but still elevated).

Most people’s wages have not kept pace with those increases, which means many households find it increasingly difficult to make ends meet. They’re hurting.

So how would raising interest rates again, when the Bank of Canada makes its next rate announcement Sept. 6, help that situation? It’s hard to imagine how it would.

The general monetary policy thinking is that higher interest rates dampen economic growth and force people to spend less, which brings prices down. That, of course, hits low-income Canadians the hardest — those who have to make choices between buying clothes, medication or eating. It has less effect on higher-income people who may have to forgo a trip to Europe or delay the purchase of a new big screen TV.

Weighing all those factors is not new for the Bank of Canada.

However, now that mortgage costs are the biggest driver of inflation, there are serious questions about whether another round of rate increases would do more to fuel inflation than reduce it.

The argument behind raising mortgage costs further is it forces people to scale back on spending in other areas, therefore bringing inflation down in those categories. There’s plenty of logic behind that. But at what point does it cause more inflation than it’s designed to reduce?

More importantly, who suffers the most? Many low- to medium-income Canadians who own modest homes already feel the pain from higher interest rates. They don’t have much, if any, discretionary spending left to reduce. There’s not a lot to cut back on when it comes to home insurance, food, prescription drugs and clothes.

Also, many households are still not feeling the full effects of today’s higher interest rates. Those with fixed-term mortgages that expire over the next 12 to 18 months will face significant price shock when they renegotiate their terms and find out they have to pay an extra five or six percentage points.

Higher interest rates take time to work their way through the economy. Considering that headline inflation is still only 3.3 per cent (down from a peak of 8.1 per cent in June 2022) and core inflation measurements continue to fall, it would seem unwise to raise interest rates right now, especially if doing so has the unintended effect of driving up inflation further.

tom.brodbeck@freepress.mb.ca