Governor of the Bank of Canada Tiff Macklem delivers a speech on monetary policy at a Calgary Economic Development event in Calgary on March 20.Jeff McIntosh/The Canadian Press
Kevin Yin is a contributing columnist for The Globe and Mail and an economics doctoral student at the University of California, Berkeley.
No one’s life is getting any easier as Canada and the United States enter a bizarre and destructive trade war. But one man’s job in particular just got a lot harder: that of Tiff Macklem, the Governor of the Bank of Canada.
Normally, a central banker’s job is, in some sense, rather straightforward. When the economy is weak, cut interest rates to make borrowing cheaper, and when the economy is getting too hot, raise rates to make borrowing more expensive.
It is important to prevent an economy from overheating. That’s because, as incomes and demand for goods and services rise, companies want to hire more to produce more. However, eventually, their ability to supply additional goods and services is constrained by how many people are willing to work for them and the wages they would have to pay. When demand outstrips supply, that creates inflationary pressure. Higher interest rates stifle that demand and thus bring inflation down.
Underpinning all that is the idea that a better economy often comes with higher inflation. This idea is called the Phillips Curve and is a very helpful heuristic for monetary policy. Choosing the direction of interest rates is easy under Phillips curve logic; the difficult part is assessing the situation accurately (how good is too good?), then deciding by how much to adjust rates.
However, our retaliatory tariffs, and supply shocks more generally, are different. They increase the risk of stagflation, where we can have both a bad economy and higher inflation at the same time. Retaliatory tariffs are important to disincentivize future trade attacks, but it is undeniable that they will make it more costly for Canadian companies to import raw materials and intermediate supplies from the United States in the foreseeable future.
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The portion of that cost that companies bear will curb their ability to provide us with goods and services, while the portion consumers bear will show up as higher prices.
We all know that economists have a poor record when it comes to predictions, and I certainly don’t claim any privileged status here. The fact Canadian equities fell harshly this month while inflation jumped to 2.6 per cent is evidence of stagflationary winds but doesn’t guarantee that these trends will continue. However, what has been described captures the core mechanisms at play, and it illustrates the unique dilemma that Mr. Macklem and his colleagues at the Bank of Canada are facing at the moment. Yes, when inflation is coming, we should raise rates, and when a recession is coming, we should cut them. But what exactly does one do when there is the risk of both?
This is first and foremost a quantitative question about the relative size of supply shocks and demand shocks. Taxes we impose on imports are the former, but they are not the only forces at work in our volatile new world. Mr. Trump’s tariffs and the loss of incomes on both sides of the border will simultaneously dampen demand.
People’s expectations are also crucial. If people expect inflation to become much higher, this can become self-fulfilling as companies raise prices to pre-empt the expected price rise. How the tariff burdens fall across producers and buyers also matters and depends on how badly consumers want the goods they are currently buying.
Moreover, with the Trump bull in the White House china shop, new crises can always emerge. How big these factors are, and to what extent they pass through various channels, will determine their ultimate relevance to the Bank of Canada’s rate policy.
Mr. Macklem’s statement on March 20, in which he announced a wait-and-see approach, is entirely understandable in this context. The central bank’s credibility depends on Mr. Macklem making good on promises that he makes to markets. Since he cannot be certain of the environment, he must avoid making any promises he may not be able to keep. But this is not a costless posture either – uncertainty itself can be a drag on the economy. And this strategy does not solve the conundrum, it merely provides the flexibility to address the more dominant forces in real time as they become clear.
My gut feeling is that the recession risks will dominate, because the effect of U.S. tariffs on Canadian demand will be enormous, and unless we see large resulting wage increases, our own import tariffs should lead to temporary, not lasting, inflation. But again, this rests on critical assumptions about a whole host of factors, and the models the Bank of Canada uses to evaluate the impacts of the combination of these headwinds are likely not providing conclusive arguments about what to do. In times like these, it is a wise central banker who knows the models by heart but trusts none of them.