Canada’s fight against inflation: Bank of Canada could induce a recession

Fast Facts:

The Bank of Canada is pursuing a strategy to tackle inflation by raising interest rates to bring inflation down by 5.7% points (from the May CPI figure of 7.7% to its target of 2%).

History tells us this never results in a “soft landing”:

• In modern Canadian history, going back to 1961, there have already been three periods in which the CPI has fallen by at least 5.7 percentage points: 1974-76, 1981-83 and 1991-92.
• In every single instance of CPI reductions of this magnitude in the past 60 years, it was always accompanied by a recession.
• Even if the Bank of Canada expanded its inflation target to 4%, history tells us that the success rate of a soft landing would be 33%; i.e., two out of six episodes got us to target without a recession.
• Using rapid interest rate hikes to deflate the economy is a blunt, non-targeted approach that creates tremendous collateral damage:
• If the Bank of Canada targets 2% inflation, history tells us that to get there we would see the employment rate fall, on average, by 2.7%. This is the equivalent of almost 850,000 Canadians losing their jobs.
• The worst recorded job loss while fighting inflation occurred in 1981-83, when the employment rate fell by 4.2% from peak to trough. With today’s population, that would be the equivalent of 1.3 million Canadians thrown out of work.

It’s time for a new policy on inflation that isn’t just “jack up interest rates.” That old approach will drive us right back into another recession.

The Bank of Canada's 2% target

Following the December 2021 renewal of its mandate, the Bank of Canada has been directed to keep consumer inflation in a channel between 1% to 3%, with a target of 2%. This was reinforced by the finance minister herself in her recent inflation plan.

But why 2%?

One might assume that it was the result of an extensive economic study showing that this level of inflation led to the strongest long-term growth, for instance—however, one would be wrong.

As best that anyone can determine, the 2% goal was the result of an off-the-cuff remark from a New Zealand finance minister when pressed on an inflation target in a 1988 TV interview.

In the 1990s, 4% CPI targets were common, as was the case in the U.K. in 1992, and calls to for a 4% target were once again made by prominent economists after the Great Recession (see here and here). Shockingly, there remains little empirical justification for a having one target over another.

That being said, the Bank of Canada is committed to its 2% target. To get from here to there, we’d need to see the Consumer Price Index (CPI) fall from its May 2022 value of 7.7% down to the Bank’s target of 2%, or a 5.7% point drop.

Bank of Canada Governor Tiff Macklem isn’t unique in attempting to produce a “soft landing”, where increases in the overnight rate can pull just enough money out of the economy through higher interest rates to tamp down inflation without causing a recession.

It’s worth asking, have we actually ever seen a 5.7% point drop in CPI without experiencing a recession?

In modern Canadian history, going back to 1961, there have already been three periods in which the CPI has fallen by at least 5.7 percentage points: 1974-76, 1981-83 and 1991-92. The details of what happened then are disturbing.

In every single instance of CPI reductions of this magnitude in the past 60 years, it was always accompanied by a recession. If modern Canadian history is an indicator, there is a 0% success rate of reducing inflation by 5.7 percentage points and avoiding a recession.

In fact, each of those recessions was preceded by substantial Bank of Canada interest rate hikes, which played in important role in producing a recession, among other factors.

There is simply no historical precedent for the Bank of Canada engineering a “soft landing”. Each time the Bank of Canada has attempted such engineering through rapid interest rate hikes—which it appears to be set on doing now—it resulted in a crash landing, i.e., recession.

Using rapid interest rate hikes to deflate the economy is a blunt, non-targeted approach that creates tremendous collateral damage.

The Bank of Canada doesn’t have to stick to a 2% inflation rate target; it actually has a slightly higher band that runs up to 3%. It would still be consistent with hits mandate to shoot for a 3% inflation rate target. This approach might acknowledge new language in this mandate: “…seek the level of maximum employment needed to sustainably achieve the inflation target.”

Although it’s not a “dual mandate” of balancing employment and inflation, like the U.S. Federal Reserve is pursuing, an explicit acknowledgement that there is a labour market impact to inflation targeting would make sense.

But even with a higher target of 3% for inflation, the success rate of avoiding a recession remains 0%—there aren’t any additional instances of a 4.7 percentage point drop in inflation (i.e. 7.7 – 3=4.7) that have succeeded in avoiding a recession (Table 1).

If the bank targeted a 4% inflation rate, like some economists discussed during the Great Recession, then the success rate of reaching inflation reduction without a recession would increase to 33%.

There were six such episodes where the CPI fell by 3.7 percentage points in the past 60 years (i.e., 7.7 - 4 = 3.7): the three we examined in Table 1 and three additional episodes in 1969-70, 2003-04 and 2008-09. Two out of these three new episodes didn’t result in a recession (1969-70 and 2003-04). The third one, in 2008-09, certainly did, as Canada entered the Great Recession.

However, Bank of Canada interest rates in this second set of inflation reductions were either small or non-existent. Prior to the 1969-70 episode, there were Bank of Canada rate increases amounting to 2.5% points over two years before the inflation peak. In the 2003-04 episode, the bank’s rate rose by 0.75% points compared to a year before. In the 2008-09 episode, the bank’s rate had actually fallen before the inflation peak.

In any event, even if the Bank of Canada target was 4% inflation (instead of 2%), the success rate of a soft landing would be 33%; i.e., two out of six episodes got us to target without a recession. These are still terrible odds, but at least there have been instances of inflation decreases without a recession.

But the conditions in which Canada avoided recession are important: they happened when the Bank of Canada rate increases were small or non-existent and when the inflation decreases sought were smaller. For instance, if our inflation target today was 4%, not the traditional 2%.

Inflation reduction and job losses

Recessions often discussed in rather dry terms of two quarters of negative real GDP growth. The practical impacts on regular Canadians through job loss and suppressed wages are often under-appreciated. Canada’s population has grown over the past 60 years and Table 3 produces estimates of job losses based on that 2022 population figure, given the change in the employment rate experienced in previous instances of inflation decreases from Table 1.

If the Bank of Canada targets 2% or 3% inflation, history tells us that we could see the employment rate fall, on average, by 2.7% points. This is the equivalent of almost 850,000 Canadians losing their job.

The worst recorded job loss while fighting inflation occurred in 1981-83, when the employment rate fell by 4.2% from peak to trough. With today’s population, that would be the equivalent of 1.3 million Canadians thrown out of work.

The job losses in the 1981 and 1991 inflation-reduction periods occurred during a time of massive structural change in the labour market, including the free trade agreements and internationalization of production.

Conclusion

Any way you slice it, a fight against inflation using interest rates will also be a fight against jobs. There is no precedent for this scale of interest rate increases to tackle inflation that did not result in a recession in Canada. If the bank’s target is 2% to 3% inflation, then there is a 0% success rate of getting there without a Bank of Canada-induced recession. If the Bank of Canada would set a higher inflation goal (say, 4%) and mute interest rate increases, then there is a 33% success rate of getting there without a recession.

Judging from history, it would be normal to see 850,000 Canadians lose their job in the upcoming fight against inflation if it were driven by rapid interest rate increases. In the worst historical case, equivalent job losses today would exceed 1.3 million.

The irony here is that the economy and labour markets are strong, with the unemployment rate sitting at 5.1% in May, below where it stood pre-pandemic. Yet despite a strong labour market, workers haven’t seen wage increases keep up with the rate of inflation, so a majority Canadians are falling behind in real purchasing power.

We need to be honest about what fighting inflation with interest rates means: it likely means a recession with, on average, over three-quarter-of-a-million Canadians losing their job. A Bank of Canada-induced recession would clarify that inflation policy is inherently also income distribution policy because workers’ wages won’t have time to catch up to inflation as recession hits and subsequently suppresses wages.

It’s worth remembering that inflation is primarily being driven by the unjust war by Russia on Ukraine, driving up gas prices, and supply chain issues in China. Notwithstanding these external issues, it’s Canadian workers who might pay the price. Wage gains in the past year are far behind inflation. A recession caused by rapid interest rate increases won’t give workers a chance to make better gains.

While corporate profits typically dip, as a proportion of GDP, early into a recession, they didn’t during the pandemic-induced recession. In fact, corporate profits have captured three times more economic growth in this recovery than after any recession in the past 50 years. The effect has been to reshuffle who benefits from economic growth, moving away from workers’ wages in favour of corporate profits.

It’s time for a new policy on inflation that isn’t just “jack up interest rates.” That old approach will drive us right back into another recession.

Methodology

The Bank of Canada doesn’t focus on the all-item CPI for its inflation targeting. Instead, it has developed three related measures (common, median and trim), which attempt to focus on “core” inflation that avoids some of the rapid swings that can happen to the all-items figure. Unfortunately, these three measures that are preferred by the bank today only have data going back to January 1990, limiting their utility in this longer historical analysis. In this analysis, the all-item CPI is used instead.

However, as a check on the conclusion, an identical analysis was performed utilizing the all-item CPI (excluding food and energy), whose data goes back to January 1961. This longer-term series excludes two factors that are known for greater variability, i.e., food and energy prices, and better matches the “core inflation” concept that the bank focuses on today. Excluding food and energy, the CPI saw prices rise by 5.2% between May 2021 and May 2022. This is a lower increase than recorded by the all-item CPI, at 7.7%. Therefore, a smaller decrease in the CPI would be necessary to hit the 2% inflation target of the Bank of Canada. Inflation would have to drop from 5.2% to 2%—a 3.2% point drop.

With that in mind, Table 4 examines all instances in modern Canada history in which the CPI (excluding energy and food) fell by at least 3.2% points. As with the main analysis above, there are three episodes in which the desired drop has happened, the same as Table 1 with the all-item CPI. The inflation high dates are not quite identical to Table 1, but they do fall within a few months. The eventual low point of inflation, excluding energy and food, falls much later than in Table 1, which utilizes the all-item CPI. The total fall in annual inflation, from peak to trough, is similar between the two approaches.

Broadly, using a more core-focused CPI measure instead of the all-item measure doesn’t change the conclusion: the Bank of Canada has a 0% success rate in bringing down inflation to its 2% target without a recession.

Acknowledgements: Special thanks to Sheila Block and Jim Stanford for their helpful comments on an earlier draft of this analysis.