The Combat of Inflation in Post-Pandemic Time

The Combat of Inflation in Post-Pandemic Time
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The Combat of Inflation in Post-Pandemic Time
1 The experience of fighting inflation in Canada and the U.S. in 2022
Interest rates are one tool used by central banks to adjust the money supply and regulate the economy. While monetary policy has lived under many guises, central banks' main role, such as the Bank of Canada and the U.S. Federal Reserves, is to adjust the money supply in the economy and achieve output stabilization and inflation (Mathai, 2022). Events such as the global energy crisis, Russia's invasion of Ukraine, on-and-off lockdowns, and the supply bottlenecks in the pandemic era have resulted in the rising prices of energy, flights, and interest rates (Liboreiro, 2022). During this time, central banks such as the Bank of Canada promoted the financial and economic welfare of the country as directed by the Bank of Canada Act (Lecture Notes 2, n.d). Accordingly, the central banks raise policy rates intending to cool inflation. On December 7, 2022, the Bank of Canada increased its target for the overnight rate to 4¼% with the deposit rate at 4¼% and Bank Rate at 4½%.
Additionally, the Bank is continuing its quantitative tightening policy as global inflation remains high. In the third quarter, Canada's gross domestic product (GDP) growth remained stronger than anticipated as the economy continued to grow in excess demand. In October 2022, Consumer price index (CPI) inflation was 6.9%, with most of the goods and services regularly bought by Canadians witnessing significant price increases. Core inflation has remained at 5%. The Bank of Canada expects to announce its next overnight rate target on January 25, 2023 (Bank of Canada, 2022). Effective December 15, the Federal Reserve announced an increase in the interest rate on reserve balances to 4.4%. Besides, effective December 15, 2022, the U.S. central bank approved a ½ percent point increase in the primary credit rate to 4.5 percent (Federal Reserve, 2022a). Such monetary policies in Canada and the United States are critical in cooling inflation.
2 The rationale for raising interest rates
Higher policy rates affect asset prices, exchange rates, commercial interest rates, and people's expectations of future economic growth, interest rates, and inflation. Interest rate changes affect the prices of various assets, such as stocks, bonds, and houses. In particular, higher policy interest rates can increase asset prices. For instance, an increase in interest rate can increase the cost of external financing of a firm by issuing equity or bonds. Such changes can hinder production and investment and subsequently lower household income through dividends, wages, and wealth. Besides, an increase in policy interest will decline household consumption and decrease demand for production goods and equities and investments in bonds due to a decline in wealth and income. Such factors function to impact the prices of stocks and bonds negatively. Another example of the impact of higher policy interests on asset prices is the increase in mortgage rates. Raises in mortgage rates will increase the cost of purchasing houses due to the increasing interest burden (Lecture Notes 2, n.d). The increasing interest burden will consequently suppress housing demand and affect house prices.
Changes in interest rates can also affect exchange rates. Generally, increasing interest rates in Canada relative to other countries' rates will make Canadian dollar-dominated assets more attractive to domestic and foreign investors. This attractiveness will increase the demand for and the value of the Canadian dollar compared to other currencies. As a result, a stronger Canadian dollar will result in many imported goods and other Canadian products competing with them to be cheaper over time (Lecture Notes 2, n.d). Canadian products will also tend to be costly in foreign markets, reducing demand and negatively impacting inflation.
Bank policy interest rates affect commercial interest rates such as commercial loans, mortgages, consumer loans, and deposit rates at financial institutions. This implies that low commercial interest rates will reduce the cost of borrowing and encourage spending, borrowing, and investing. A decrease in commercial interest rates also reduces the money paid on interest-bearing deposits, discouraging saving. As a result, over time, there will be an increase in overall demand for goods and services. The opposite is true when commercial interest rates increase. Although changes influence the pace and direction of these changes in market interest rates in policy rates, it is critical to observe that there is often no one-to-one correspondence (Lecture Notes 2, n.d). For instance, commercial lending rates are always affected by market forces such as competition among lenders in particular markets, raising capital, the cost for lenders, and the perceived creditworthiness of the borrowers.
Increasing policy interest rates impacts people's expectations of future economic growth, interest rates, and inflation. People's expectations can affect firms' and households' decisions about current investment and saving patterns, wages, asset prices, and prices of goods and services. For instance, if people anticipate an increase in inflation in the future, there will be a rise in longer-term interest rates to reflect their expectations. Since 1997, Canadian inflation expectations have always been anchored at 2 percent. Central banks use monetary policy instruments such as flexible exchange rates and the inflation-control target to promote countries' financial and economic welfare. The inflation control target ensures that Canada maintains inflation of 2 percent, which is the midpoint of a 1-3 percent target range (Lecture Notes 2, n.d). Therefore, higher policy rates will help reduce inflation rates, an effect that trickles down to affect all aspects of an economy, such as households, firms, banks, and the market.
3 The perils of raising interest rates
1 The pain of raising interest rates
1 Businesses and households on the receiving end
Later in 2022, the aggressive rate increases by both the United States and Canadian central banks witnessed severe backlashes. Today, households and businesses are feeling the impacts and have harshly criticized the central banks for this move. Politicians often say that there are multiple ways of fighting inflation. An economy with a benevolent government will always experience a tradeoff between maximizing employment and fighting inflation. For instance, on the one hand, governments will tend to keep inflation low and steady as a welfare-improving strategy.
On the other hand, the same government will tend to increase inflation because low inflation is often associated with increased unemployment based on the Philips curve. Although there is a short-term tradeoff between inflation and unemployment, it is not always in the long term. The government may delegate authority to the Central Bank to define inflation and monetary policies. Governments can reduce inflation by delegating policy-making authority to a more conservative central bank. Conservative central banks trade off more volatile unemployment for mild and stable inflation. In this perspective, it would be more optimal for governments to have delegative authority in designing monetary policies that would reduce inflation to a more conservative central bank than itself (Lecture 5, n.d). This delegation is critical in checking inflation in many countries, such as the United States and Canada.
2 Governments on the receiving end
Increased interest rates may lead governments to feel the impact of inflation. In the recent past, both the United States and Canada have felt the impact of increasing interest rates on government bonds, stocks, and interest payments. The United States has witnessed six interest hikes in 2022, the first time in decades since the Federal Reserve acted vigorously to slow down inflation. Markets have reacted strongly to Jay Powel, the Fed Chair, claiming that interest rates will be higher than previous expectations. Increased interest rates negatively impact people's net worth. Major stock indexes such as Dow Jones Industrials witnessed an 800-point negative after observing that interest rates were going up (Solman & Estes, 2022). Such hikes in interest rates hurt the prices of stocks, bonds, and interest payments.
2 A potential recession?
The World Bank defines a recession...