Central bankers are in a tough spot. They would like to curb inflation, but they know that raising interest rates quickly could trigger a recession.
In the 1970s central bankers lost the battle with inflation for many years, and eventually they were forced to raise interest rates as high as 20 percent.
Can central bankers stop inflation without taking such drastic measures this time?
Recently Jerome Powell of the Federal Reserve reassured stock markets that he would raise interest rates at a measured pace, by 50 basis points at a time. He took this moderate tone while outlining his gradualist approach, despite the fact inflation is over 8 percent. Powell reiterated his belief in a “soft landing”, where the Fed gets inflation under control but avoids a recession.
In a speech by a Deputy Governor of the Bank of Canada, Toni Gravelle, there is a discussion of the 1970s and stagflation. Stagflation is a nightmare scenario as inflation erodes the purchasing power of money while the economy is stagnant.
Gravelle addresses 1970s stagflation in his speech https://www.bankofcanada.ca/2022/05/the-perfect-storm/ The Perfect Storm, mentioning that inflation was pushed even higher when workers were able to negotiate large wage increases. Unions in the 1970s wielded more power than today, and many more workers were members of unions.
He recognizes that central banks need to fight inflation and policy actions are designed to “reduce excess demand and to bring it more into balance with supply.” He mentions “housing” as an industry that is experiencing excess demand.
The main tool central bankers use to restrain excess demand is raising interest rates. Housing, in all its aspects, is a key industry in Canada and is the most important sector for central bank actions to have an immediate and direct influence.
But higher interest rates can be very negative for the housing market and related activities. This is one reason that the Bank of Canada has delayed taking this action for so long, allowing and even encouraging the housing bubble to grow bigger and bigger. Until recently the Bank of Canada seemed more interested in supporting the housing market with lower and lower rates.
The increased cost of money reduces discretionary income for all households that have a mortgage, and the impact is felt by some right away and all the others within five years. With the recent popularity of variable rate mortgages, the housing sector is more sensitive than ever to higher rates. And potential first-time-buyers will cancel their plans if they do not qualify for a loan.
Gravelle mentions the record high levels of household debt. He says, “we could see a larger-than-expected slowdown due to higher indebtedness and unsustainably high housing prices.”
We are about to see if the Bank of Canada has the determination needed to get inflation under control, even if that takes much higher rates and much longer than expected.
Or will the Bank of Canada reverse course as soon as the housing market falters, and recession warnings grow louder?
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