The Bank of Canada is raising interest rates to return inflation to target, and Governor Tiff Macklem says Canada’s red-hot labor market can weather an economic slump without seeing a major surge in unemployment—Reuters, November 10, 2022
What is Canada’s inflation rate and what is its inflation target?
Statistics Canada reports Canada’s inflation rate every month, and in September 2022 the CPI was 6.9 percent higher than its September 2021 level.
The Bank of Canada’s inflation target is set in an agreement with the Government of Canada and is an annual rate of change in the CPI at the 2 percent midpoint of a 1 to 3 percent inflation-control range.
Figure 1 shows the Bank of Canada’s inflation target and outcome over the 20 years to September 2022.
What feature of Canada’s labor market makes it “red hot”?
An unusually large number of job vacancies is making Canada’s labor market “red hot” in 2022. Figure 2 shows some data.
We can measure the labor shortage as the job vacancy rate minus the unemployment rate. In normal times, more people are looking for a job than the number of jobs available, and many of the job seekers don’t have the skills needed to fill a vacancy. So normally there is a surplus of labor (a negative shortage). But in 2022, the number of unfilled jobs exceeded the number unemployed—there was a labor shortage.
In September 2022, the job vacancy rate was 2.8 percentage points higher than in March 2020, before Covid. The Bank of Canada is hoping that the rising interest rate will lower the vacancy rate and not increase the unemployment rate.
Has the Bank of Canada ever lowered inflation without an increase in unemployment?
Yes, the Bank of Canada has lowered inflation without an increase in unemployment, and Figure 3 provides the data. The x-axis measures the unemployment rate and the y-axis measures the inflation rate. In 1991, the inflation rate fell from 7 percent to 1.6 percent, while the unemployment rate barely changed at around 10 percent.
What are the key differences between 1991 and 2023?
Two key differences make it unlikely that 2023 will be a 1991 rerun:
First, 1991 saw the launch of inflation targeting. New Zealand had already shown that inflation targeting works, and the Bank of Canada and Government of Canada agreed to adopt a 2 percent inflation target. Inflation expectations fell, which lowered the inflation rate without increasing unemployment. There is no equivalent monetary policy innovation in 2023.
Second, before inflation targeting began, the unemployment rate was already extremely high, which kept inflationary pressures under control. In 2022, the unemployment rate is extremely low at 5.2 percent, which is creating inflationary bottlenecks.
Can the Bank of Canada return inflation to target in 2023 without an increase in unemployment?
It is unlikely that the Bank of Canada will return inflation to target without an increase in unemployment. Figure 4 illustrates the challenge.
The figure shows Canada’s unemployment rate (x-axis) and inflation rate (y-axis) data points interpreted by the Phillips curve model. The long-run Phillips curve, LRPC, assumes a natural unemployment rate of 6 percent. Two short-run Phillips curves, SRPCMay 20 and SRPCSep 22, show the Bank of Canada’s short-run tradeoffs. They intersect LRPC at the expected inflation rate—2 percent in May 2020 and 5 percent in September 2022.
To lower inflation to 3 percent (the upper limit of the target range), with no change in the expected inflation rate, the unemployment rate will increase to about 7 percent, in a movement along SRPCSep 22.
If the Bank of Canada can credibly commit to returning inflation to target, a lower expected inflation rate will shift the SRPC downward and limit the rise in the unemployment rate.
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