Why did inflation fall from multi-decade highs last summer to within the Bank of Canada’s target range last month? It seems like a simple question, but as with most things in economics, the answer is hotly contested.
Catch up: The textbook Econ 101 story is that central banks reduce inflation by raising interest rates, which reduces demand in the economy through some combination of job losses, frozen or lower wages, and a pullback in consumer spending.
- “Higher interest rates will work to slow spending and labour demand in the economy, and over time, this will relieve domestic inflationary pressures,” Bank of Canada Governor Tiff Macklem said last November, echoing this view.
Yes, but: While the Bank of Canada has raised rates, the job losses and weaker consumer spending expected to come with that haven’t materialized—in fact, the opposite has happened.
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Since the Bank of Canada started hiking rates in March of last year, the employment rate among working-age people has held steady and around 340,000 net new jobs have been created.
- And consumer spending has increased over the same period, not fallen—retail sales are up around 3.5% over the course of the Bank’s rate-hiking campaign.
So, what happened? That’s a hot topic of debate among economists in Canada and the US, these days.
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Economist Paul Krugman attributes falling inflation to “the economy sorting out lingering pandemic-related disruptions” rather than rate hikes.
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Former US Treasury Secretary Larry Summers has a different view, arguing that central banks established “credibility” by raising rates and convinced people they would do whatever it took to beat inflation, which itself brought inflation down.
- And Harvard economist Jason Furman notes that while interest rates alone may not have brought inflation down, it’s possible that without them, prices could have spiralled even higher.
Why it matters: How the debate plays out will shape how we respond to future economic crises.
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For example, many influential economists leaned on their experience battling inflation in the 1970s to justify calls for dramatic action last year as prices rose. Larry Summers said unemployment would have to hit 10% and stay there for at least a year.
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After seeing inflation recede without job losses or a major recession this go-around, it will be more difficult to make arguments like that in the future.
Bottom line: It’s unlikely we’ll get a definitive explanation of why inflation has subsided, but that won’t stop economists from arguing about it for years to come.