Introduction
Good morning, it’s wonderful to be here in Charlottetown today to give my first public speech as a deputy governor at the Bank of Canada. I’m delighted not only to visit Prince Edward Island but also to learn more about the local economy. To do our job well at the Bank, we need to understand how our policies affect people and businesses across this vast country. That’s why I’m meeting with business and community leaders from several sectors while I’m here.
Our job at the Bank is to keep inflation low and stable, so we aim to keep it centred on a 2% target. This is how we ensure the economy works best for all Canadians. Inflation has now come down significantly and is back at 2%. We want it to stay there. For this reason, we decided last month to lower our policy interest rate by 50 basis points to 3.75%. Our focus now is on ensuring that inflation remains low, stable and predictable. We need to stick the landing.
The past few years have been difficult for Canadians. The COVID-19 pandemic caused the sharpest economic downturn in a century, which was followed by an unexpectedly fast rebound. Inflation surged to a four-decade high, and the Bank responded by increasing interest rates to levels not seen since the early 2000s. We did what we believed was necessary to restore price stability. And it worked: inflation has returned to 2%, and interest rates have started to come down. But it hasn’t been painless.
Higher interest rates were a burden for families and businesses. Inflation is back to normal, but it may not feel that way for many people. Especially if they are facing higher interest payments on their mortgages or other loans.
With all of this in mind, the Bank owes it to Canadians to assess how effective our interest rate decisions were in countering high inflation. I’ll begin by discussing the factors that led to the run-up in inflation, and I’ll explain how monetary policy worked to address them. My aim is to shed some light on the question of whether higher interest rates were really needed to bring inflation down to 2% or whether it would have returned to target on its own.
Then I’ll talk about what price stability means for us at the Bank of Canada. I’ll explain why we want inflation to stay around 2% and not fall below target. And why—even though it may seem counterintuitive—it would be painful for many Canadians if we were to try to bring about a period of price declines.
How monetary policy helped tame high inflation
Let’s begin with the sharp rise in inflation in 2021 and 2022. To better understand how monetary policy helped bring inflation down, we need to look at the factors behind inflation. We can break down these drivers of inflation in many ways. But for today, let’s think in terms of three broad categories.
The first category is made up of mostly global factors, like food and energy prices, which aren’t directly influenced by our monetary policy.
The second is inflation expectations. When businesses expect high inflation, they tend to raise prices more rapidly than normal in anticipation of future cost increases.
And the third is the amount of demand relative to supply in the Canadian economy. If demand for goods and services goes up but businesses don’t have the capacity to keep pace, prices tend to rise. When this happens across many sectors at the same time, it leads to inflation. To keep inflation stable at 2%, we need the economy to be like the third bowl of porridge in the story of Goldilocks and the three bears—not too hot, not too cold, but just right.
Monetary policy works primarily through the second and third categories.
In the post-pandemic period, inflation initially picked up because of drivers in the first category. Strong global demand for goods—combined with pandemic- and weather-related disruptions—strained global supply chains and pushed inflation in goods prices sharply higher. As economies around the world reopened, global commodity prices began to rise. Then, in early 2022, Russia’s invasion of Ukraine disrupted the supply of many commodities, sending food and energy prices soaring.
Admittedly, on its own, Canadian monetary policy would have had little effect on these global factors. This begs the question of why we bothered to raise interest rates at all. It’s a reasonable question, so I’ll try to answer it by explaining how our actions played a key role in reducing inflation here in Canada.
The first thing to note is that we were not acting in isolation. Central banks around the world were also raising interest rates. Although these actions were not formally coordinated, the synchronized nature of this tightening contributed to reducing global demand for goods. This, in turn, relieved some of the pressure on supply chains. Global tightening of monetary policy also eased commodity prices.
Clearly, the collective impact of many central banks all acting at the same time helped lessen the global pressures behind the initial surge in inflation. But as these global developments were playing out, domestic pressures were building up here in Canada. Demand, in particular, started to play a more important role in keeping inflation elevated.
So let’s now turn to how the Bank’s actions worked through the second and third categories of drivers I outlined: inflation expectations and demand in the Canadian economy.
Anchored inflation expectations were a game changer
To explain the role inflation expectations played, I need to take you back to the 1970s—another period when global forces sparked a run-up in food and energy prices.
As inflation rose in the early 1970s, people quickly came to expect that it would remain high indefinitely. Starting in 1973, Canadians lived through a decade of fast-rising and volatile prices. Inflation averaged almost 10% and peaked just under 13%. Bringing inflation back down had huge economic and social costs. The Bank’s key interest rate reached 21%, and the unemployment rate rose above 13%.
Canada’s recent experience in taming high inflation has been vastly different. Although inflation rose slightly above 8%, the policy rate peaked at 5%, and the unemployment rate has been around 6.5% since June.
This dramatic difference in performance comes down to one key variable: inflation expectations. In the 1970s, inflation expectations were not anchored. In contrast, inflation expectations were well anchored before the 2021–22 price shocks happened. This was a game changer.
Inflation climbed to levels not seen in decades. But because the Bank had committed to an inflation target of 2% and had kept inflation close to that target for 30 years, Canadians continued to believe it would eventually come back down. We reinforced that belief by committing to act forcefully to get inflation back to 2% and then following through with decisive policy action. This kept long-term inflation expectations anchored and helped bring down short-term expectations, which had moved upward as inflation rose (Chart 1).
