People have a lot of confidence in what the Bank of Canada says, and they should. It is a reputable institution that indirectly dictates what over 10 million Canadians pay for their mortgages.
But whether intentionally or not, the central bank also has a habit of saying things that make people think in a certain direction.
Despite the bank’s good intentions, sometimes this direction is not in the best interest of the borrower – literally.
Exhibit A: the infamous “temporary” inflation debacle of 2021.
Here the Bank of Canada and other central banks were busy reassuring borrowers that inflation would be temporary (that is always the case, but that doesn’t prevent interest rates from rising).
This was her story just months before she pegged Canada’s key interest rate to an Artemis II rocket, bringing it to 475 basis points in just 17 months.
This little “temporary” oopsie moment resulted in the largest percentage point migration cycle in over three decades and the largest percentage increase (from 2.45 percent to 7.20 percent) in Canadian history.
By the time the Bank of Canada got serious and tightened interest rates, inflation had already reached 5.7 percent, 370 basis points above its mandated target. That’s like taking a garden hose to the fire – after the house is gone.
Such missteps are hardly unprecedented. There is a well-documented pattern of central banks downplaying or underestimating inflation in the early stages of inflation cycles.
There can be several reasons for this.
For one thing, central banks know that their words move markets, sometimes more than the data itself.
If the Bank of Canada signals inflation alarm too early, it could trigger a self-reinforcing cycle. Bond yields are rising, mortgage rates are rising, and financial conditions are abruptly tightening.
So there is a built-in incentive to describe emerging inflation as “transitory” (“temporary” has been banned from the central bank lexicon) until the data no longer justify that stance. And usually it happens at some point, often courageously.
Second, central banks’ inflation forecasts have a documented tendency to underperform in the early stages of inflation spikes. The Bank of Canada, the U.S. Federal Reserve, the European Central Bank and others all fell behind the curve in 2021-2022.
Part of it is model-driven (their models were calibrated for an era of low inflation, which the Bank of Canada is currently trying to address), and part of it is institutional. Nobody wants to be the politician who pulled the fire alarm when there was a false alarm.
Third, they rarely know exactly where inflation will stop – until it is too late.
That’s why central bankers often favor carefully hedged phrases like “monitor closely,” “data dependent,” and “risks are balanced,” which sound reassuring until you realize they all essentially mean “we’re not sure yet.”
This language allows the Bank of Canada to maintain its optionality without explicitly telling the public, “We believe inflation is about to run hot.”
Finally, the early admission by a central bank with a two percent inflation target, such as the Reserve Bank of Canada, that it expects the target to be exceeded can undermine the credibility that anchors inflation expectations.
In fact, it’s a funny little paradox that the mandate to manage expectations sometimes leads to underestimating the risks that threaten them.
In 2021, we saw a rare candor on this issue when Bank of Canada Governor Tiff Macklem was asked how confident he was that inflation was truly temporary. He quipped: “It’s the job of central banks to say so.”
Well, I don’t know about you, but my mom always told me that there’s a grain of truth in what people say before they admit they’re joking.
Don’t get me wrong, this is not a prosecution of our central bank. There are good, dedicated officers there, and they have an incredibly important and difficult job.
What I’m trying to convey is that sometimes it’s worth (or saving) for borrowers to think independently and critically about interest rates.
As I write this, the price of West Texas Intermediate (WTI) appears to be on track to reach over $120 per barrel. If this level persists beyond a short period of time, inflation could breach the Bank of Canada’s three percent inflation tolerance (i.e. the upper limit of its inflation control band).
If history is any guide, the ultimate result of such a shock would be an economic slowdown. But unlike the US Federal Reserve, the Bank of Canada only has one mandate: controlling inflation. So it would first have to react to rising prices.
For this reason, rate observers should pay particular attention to inflation expectations and underlying inflation at this time.
As for the underlying trend, it’s not enough to watch the annual rate of the Bank of Canada’s “average core” measure – the “preferred inflation” measure it waffled about last year.
Instead, people need to keep the following in mind:
- Three-month average core inflation
- CPIX (excluding energy and mortgage interest costs)
- Wage growth
- Inflation breadth (the proportion of the CPI components that grows above three percent per year).
Then we need to carefully watch how the oil shock drives them higher. And you can bet that this will be the case, regardless of how shaky our economy looks.
By the way, don’t get too excited, but the Bank of Canada says it will launch an interactive dashboard this year to show people what inflation indicators it looks at (which will be like Christmas morning for the kind of person whose browser bookmarks are exclusively central bank websites).
When it comes to the other crucial piece of the puzzle, inflation expectations, Canada does not have a timely, free and public source of high-quality inflation expectations.
The Bank of Canada only releases its numbers quarterly, which is far too infrequent to get a sense of inflation sentiment during an emerging shock.
Frankly, it’s a statistical disgrace.
If our country can spend more than a billion dollars on a firearm buyback, hopefully we can afford a few hundred thousand a year to provide our central bank (and the public) with more up-to-date monthly surveys of inflation expectations.
We’re talking about crucial data that guides policies that impact the wealth of millions of Canadians. But don’t get me started.
The main message is clear, even if I don’t think so: don’t rely too much on central bank messaging.
Do your own interest rate homework and consider securing all or part of your mortgage if you still have more than five years left and need to protect yourself against a possible increase in interest rates.
What we are seeing in the Middle East poses a serious threat to interest rates. It is quite possible that the Bank of Canada will have to make several rate hikes this year, despite the inevitable economic damage that this crisis will cause.
If so, it is also possible that our central bank will tell us – too late.
Robert McLister is a mortgage strategist, interest rate analyst and editor of MortgageLogic.news. You can follow him on X at @RobMcLister.
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