CANADA ECONOMICS FEATURE: CIBC's Andrew Grantham On 'A New Year's Resolution For Central Banks'
02:46 PM EST, 12/22/2023 (MT Newswires) -- Andrew Grantham has written this week's 'The Week Ahead' note for CIBC Economics.
Grantham wrote: "It has become fashionable in recent years to criticize central banks for their actions during and after the pandemic. However, in many cases this is an example of throwing stones in glass houses, as very few of those commentators pointed out the mistakes at the time. Moreover, simply pointing out a mistake now, but not trying to understand why it came about, doesn't help spot or prevent future errors. Most of the missteps that we now realise were made by central banks in recent years had one common element -- treating fluctuations in supply as if they were changes in demand.
"The pandemic itself was a supply shock, particularly after governments stepped in to protect incomes lost due to shutdown measures. Ultra-low interest rates therefore caused excess demand in areas that were still open, particularly housing. The stall in the recovery during 2021 stemmed from supply disruptions, particularly in the auto industry, rather than a weakening in demand and thereby a widening of the output gap. For all the criticism it has received, the Bank of Canada was actually a frontrunner globally in recognising this and changing its approach to measuring slack within the economy. However, more recently the BoC's rate hikes this summer were possibly an overreaction to a temporary acceleration in growth driven by the partial easing of earlier supply constraints in the auto sector. The New Year's resolution of central banks should be to better understand the supply side of the economy.
"Unfortunately, New Year's resolutions are often broken, including my own yearly pledge to lose weight. So, what mistakes could be made in 2024 if policymakers continue to confuse trends in supply for those in demand?
"In the U.S., the Federal Reserve needs to avoid the temptation of cutting interest rates too early or quickly. Inflation could well touch 2% briefly over the summer, as goods prices continue to fall from their earlier peaks. The larger spike in goods prices in the U.S., in part because of the higher weight for used cars, always created more room for disinflation as supply issues faded. However, this is a largely supply-driven and possibly temporary source of disinflation. Demand for consumer goods in the U.S. has continued to rise, despite already being elevated relative to its pre-pandemic trend. Cutting interest rates as early and quickly as financial markets are currently expecting, before demand materially slows, could spark the return of inflation come 2025.
"For Canada, a premature easing of interest rates should not be a concern, as household consumption has already slowed materially. Most of the inflation that we are now witnessing is supply driven, notably the inability of housing supply to keep up with population growth. While policymakers recently acknowledged that excess demand has faded, in reality most areas of domestic demand have not been excessive relative to their pre-pandemic trend for over a year, with the notable exception of government spending. The risk for Canada is that the Bank hangs onto a hawkish stance for too long, creating a prolonged period of sluggish economic activity and eventually below-target inflation by 2025.
"Both central banks should be well aware of these risks, and if they stick to a New Year's resolution of not overacting to supply-driven trends in growth and inflation we should see more interest rate cuts from the Bank of Canada in 2024 than the Federal Reserve."
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