Navigating high inflation

On June 1, the Bank of Canada decided to increase its policy interest rate by half a percentage point. Speaking the next day, Deputy Governor Paul Beaudry explains why inflation has been higher than expected and what we are doing to get it back to our 2% target.

Our policy rate decision

On June 1, the Bank of Canada increased its target for the overnight rate by half a percentage point to 1.5%. The Bank is also continuing its policy of quantitative tightening.

Economic update since April

The Canadian economy has recovered quickly from the effects of the COVID-19 pandemic. The rebound has been stronger and faster than we anticipated. Wage growth is back to pre-pandemic levels, and unemployment is at a record low. We expect these trends to continue.

But high inflation is squeezing budgets for families and increasing costs for businesses. And inflation will remain high in the coming months. This is painful for everyone, especially those on fixed or low incomes.

Preventing high inflation from becoming entrenched

Our main concern is bringing inflation back down to make buying essentials less expensive for Canadians and to ensure higher inflation doesn’t become entrenched.

Inflation becomes entrenched when it feeds on itself. Prices rise because other prices are rising and because the cost of labour is going up. In a situation like that, inflation becomes self-fulfilling because households and businesses expect that it will stay high or keep rising, and they act accordingly.

While inflation in Canada is too high, it is not yet entrenched or self-fulfilling. Clear outside forces, such as ongoing supply disruptions and Russia’s invasion of Ukraine, are currently driving the inflation we are experiencing.

Nevertheless, the Bank is acting to bring inflation back down and stop it from becoming entrenched. History shows that once high inflation does become entrenched, it’s hard to bring it back down without hurting the economy.

Domestic versus international drivers

Two main sets of forces are driving the current high inflation—one is domestic, and the other is international.

In recent months, excess demand in the Canadian economy has pushed inflation higher. Central banks respond to excess demand by raising interest rates. The Bank of Canada started doing so in March because that’s when we saw that the Canadian economy was back at full capacity.

But international developments have pushed inflation the most over the past year. The global recovery from the pandemic sparked supply shortages in sectors such as energy, electronics, and many consumer durables. The war in Ukraine amplified these issues, causing prices to soar even further.

Domestic economies can’t control the prices of internationally traded goods. And the impact of inflationary shocks from abroad is usually temporary. So, central banks typically don’t react to such inflation by raising interest rates.

Balancing trade-offs

Decisions around monetary policy often involve trade-offs.

When inflation started to rise last year, we opted against raising interest rates, not only because inflationary shocks from abroad tend not to last long but also because we wanted to ensure those who lost their job during the pandemic could get back to work.

The situation today is different.

The initial shocks to global supply chains have lasted longer than expected and were made worse by the war in Ukraine and renewed lockdowns in China. The risk is greater now that inflation expectations could rise and high inflation could become entrenched. To prevent this, interest rates need to be higher.