The risk is that some may see that as reason to begin relaxing monetary and fiscal restraint. History tells us that policymakers should resist the temptation.
We are seeing clear signs that price pressures are easing, with inflation on track to fall below four per cent within a few months from 6.3 per cent in December and from as high as 8.1 per cent in June. On the labour side, a monster employment gain of 104,000 last month suggests the expected downturn this year could end up being very mild.
There’s a real possibility the country will experience a mild recession strong enough to curb inflation, but not so strong as to cause a major loss of employment — a real Goldilocks outcome. But the best chance of attaining that scenario is to stay the course on tight demand policies, which should include another quarter-point hike by the Bank of Canada on Jan. 25.
The central bank will revise its forecasts this week, but in October it projected inflation will average 4.1 per cent in 2023, a drop from 6.8 per cent last year.
Since the Second World War, there have been only a small number of one-year disinflationary episodes of that magnitude. It happened in 1983 and 1992, but only after severe monetary tightening triggered deep recessions.
It also happened in 1976, the year Trudeau père introduced wage and price controls to slow inflation that had risen to as high as 12 per cent. But those efforts were for naught.
A combination of premature easing of monetary policy and lack of fiscal discipline — in part because policy makers let their guard down — allowed inflation to take off again and return to double digit levels. Those policy mistakes would eventually force the Bank of Canada to drive short-term rates to above 20 per cent in the early 1980s, causing perhaps the deepest downturn since the Great Depression.
A more useful guide, we believe, for today took place 70 years ago, as the start of the Korean War in 1950 sent inflation shooting to as high as 13 per cent. Douglas Abbott, finance minister at the time under Prime Minister Louis St. Laurent, aggressively moved to rein in demand even as the economy began to slow. He imposed surtaxes on both companies and households, while the Bank of Canada used its influence with commercial banks to slow credit.
Large defence expenditures induced excess demand, but it was a tighter fiscal stance that rebalanced demand with supply to relieve inflation pressures. The recession was shallow because inflation expectations did not follow actual inflation higher. It worked. Inflation would average about one per cent for the next decade.
These four disinflationary episodes provide two key lessons.
First, inflation expectations matter and determine how tight policy needs to be and so how deep the recession will be. The painful and costly disinflations of the 1980s and 1990s were the product of stubborn and high inflation expectations. In contrast, the absence of high inflation expectations during the Korean War meant the recession was short-lived, with fiscal policy doing the heavy lifting.
Second, fiscal policy matters for monetary policy. If demand needs to be reined in and fiscal policy doesn’t help, then the Bank of Canada needs to do the heavy lifting. Today the federal government is more concerned with redistribution than economic management, meaning that interest rates have to go higher than they otherwise would.
Yet today’s inflation expectations, especially long-term market-based expectations, remain well anchored suggesting a deep disinflationary recession is not necessary and shorter-term expectations are moderating.
After failing to identify the crisis early on, the Bank of Canada has put together a master class of inflation expectations management with a determined hiking cycle that is beginning to bite. Federal and provincial governments have been less helpful, and while not adding to the problem the bank has to tighten more than it would in the absence of a tighter fiscal stance.
The Bank of Canada cannot yet contemplate easing its monetary stance until it is sure that its job has been done. The coming downturn will be painful, particularly for indebted households suffering from rising debt payments. Finance Minister Chrystia Freeland and her provincial counterparts will feel political pressure to address some of the economic challenges many Canadians will face this year.
But it would be a shame to risk progress that has been made for short-term political expediency. We’re almost there. As the British proverb goes, there is no fatigue on the day of victory.
Theo Argitis is a managing director at Compass Rose Group. Andrew Spence is an independent consultant specializing in economics, investment strategy & risk.