Keeping inflation at 2%

In his first public speech as a deputy governor, Rhys Mendes explains why higher interest rates were needed to get inflation back down to the 2% target and why we want it to stay there.

Monetary policy worked to bring down inflation

The Bank of Canada responded to the highest inflation in 40 years by forcefully raising interest rates. And it worked: inflation is back at our 2% target, and interest rates are coming down too.

The process hasn’t been painless though. Elevated interest rates have been tough on families and businesses. Many Canadians are now facing higher interest payments on their mortgages and other loans. And even with inflation back at our target, many necessities cost much more than they did before the COVID-19 pandemic began.

A lot of the rise in inflation was due to global factors that the Bank can’t influence on its own, such as strained supply chains and high commodity prices. So it’s fair to ask whether raising interest rates was the best response. But monetary policy played a decisive role in bringing inflation down.

Stable expectations made it easier to get back to 2%

Even as inflation reached 8%, Canadians continued to believe we’d be able to get it back to 2%. This was because we:

• kept inflation near 2% for 30 years before the pandemic
• backed up our pledge to bring it down by raising interest rates to levels not seen since the early 2000s

Keeping inflation expectations anchored around 2%:

• limited how high inflation could rise
• made it easier for us to get it back to target

But in the 1970s, central banks didn’t have the same credibility that we do today. So high inflation was much harder to tame. At that time, inflation reached 13%, the Bank’s policy interest rate reached 21%, and unemployment topped 13%. In the latest episode of high inflation, our policy rate peaked at 5% and unemployment has been about 6.5% since June.

High interest rates cooled excess demand

As pandemic-related restrictions were lifted, Canadians wanted to catch up on things they had missed—like eating out and travelling. But many businesses were struggling to reopen and were dealing with capacity pressures. So by early 2022, demand was growing much faster than supply—there was excess demand. And at the same time, the factors straining supply globally were raising costs for Canadian businesses.

When the economy has a lot of excess demand, it’s easier for businesses to pass increased costs on to their customers. The effects of the global supply shocks were being amplified by excess demand here in Canada.

The economy works best when inflation is at 2%

We’re as concerned with inflation that is too low as we are with inflation that is too high.

After the higher-than-normal inflation everyone has just been through, a period of no price gains or falling prices can sound like a nice idea. But when prices are increasing by significantly less than 2%, it’s usually because the economy and the job market are in bad shape. Many Canadians would not feel better off.

Inflation expectations could also start to shift down, making it harder to get inflation back up to 2%.

Now that inflation is back at 2%, we want it to stay there. When inflation is low, stable and predictable, households and businesses can plan and invest with confidence, and the economy works better for everyone.