this post was submitted on 12 Jul 2023
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I really don't get this at all.
On one hand, I get that inflation is just the expression of the supply/demand curve and that increasing interest rates makes it more expensive to borrow money and therefore lessens demand and should, theoretically drop inflation.
But...
Anyone with half a brain knows that this round of inflation wasn't caused by overheated demand. It was driven by supply chain issues caused by the pandemic, avian flu, climate change and the Ukraine war. The price of oil alone drove much of the inflation numbers, both directly and indirectly by increasing the cost of production and shipping of other goods.
Does anyone at the BOC seriously think that 10%+ inflation in groceries was caused by overheated demand? Do they seriously think that people should be buying less food to lower grocery demand and reduce prices? Do they think that people will?
Does anyone think that the 6-12 month waits for a new car that are typical now is because gazillions of people are suddenly wanting to buy all at the same time? OK, there probably is pent up demand due to the fact that virtually no new cars were available during the pandemic, and lots of people want EV cars now, but the truth is that availability is way down compared to pre-pandemic times.
I see talking heads from the finance sector on TV all the time saying stuff like, "We need to tame an overheated economy...". DO WE? And then claiming that the interest rate hikes are working because inflation has come down. Yeah, right. Far more likely is that the supply chain issues are getting resolved, and supplies are increasing.
The truth is that the BOC has only one knob that they can turn, and that's the interest rates. So they're going to turn it. And the prevailing wisdom says that it takes close to 18 months for interest rates hikes to have an impact. So the downturn in inflation that started at the beginning of the year has virtually NOTHING to do with the big jump in rates that happened last spring.
As to that 18 month lag, it's probably even longer this time around because of the mortgage situation in Canada. Those people with huge mortgages have, to large degree, 5 year terms. So a comparatively small number of those people have had to renew under the new rates. And even if rates start to come back down next year, we're still going to see an increasing proportion of those mortgagees get hit with huge increases to their payments. And that's going to suck money out of the economy - big time. Are those people already tightening their belts, before they renew? Probably to some extent, but there's nothing like seeing an extra $2K-3K come out of your bank account each month to make it real.
Certainly some of inflation is caused by a decade of rock bottom rates. Our real estate bubble is probably partially caused by this
Ultimately, the BOC has a mandate to fight inflation, and very few levers to use. They cannot fix the supply chain issues, but they can quash demand, so that is what they will do
Can they? Remember, it is interest costs that are driving inflation.
https://www150.statcan.gc.ca/n1/daily-quotidien/230627/dq230627a-eng.htm?indid=3665-1&indgeo=0
We've entered this interesting feedback loop where the higher the interest rates go, the higher the interest costs go, the higher inflation goes, the cheaper it becomes to service debt (debts shrink in an inflationary environment), the more compelling it is to carry such debt, the higher the interest rates go, the higher the....
While it is incorrect to say that the BoC only has one lever, it is true that they have few tools to work with. It is unlikely that any of their tools are appropriate for the situation we face now. Raising interest rates certainly won't solve the problem β it is the problem.
When your only tool is a hammer then everything is a nail.
I think this is the issue we are seeing aroumd the world now: central banks have the mission to keep inflation around 2% and the only tool the have is the amount of money they are creating, aka the interest rate.
So even if inflation is caused by external factors the central banks are still trying to bring it down to 2% by using the only tool they have.
Funny thing is that inflation is, excluding mortgage costs, 2.5% YoY, which is within the target range. The tool they are wielding is specifically what is causing high inflation.
QED