War impact, lending boom mean inflation expectations will likely rise despite latest rate hike

In the current roar of high inflation, last week's quarter-point increase in interest rates by the Bank of Canada will likely be a whisper too quiet for most Canadians to hear.

According to a flurry of statements and speeches, including testimony to a parliamentary committee, the central bank's governor, Tiff Macklem, has begun his long-awaited attack on inflation that's meant to convince Canadians they should not expect price rises to continue.

Rate hikes, the Bank of Canada governor said, were "needed to keep inflation expectations well anchored and to limit the broadening of inflationary pressures so that inflation falls back as supply disruptions ease."

But while the central bank battles to quell inflation expectations, the world economy is conspiring to send a very different message.

Russia's attack on Ukraine has driven energy prices sharply higher, and Canadians who have not yet invested in an electric vehicle have never seen pump prices at this level. Global food prices are expected to surge as grain and fertilizer suffer shortages.

The loss of production from an entire country, Ukraine, and economic sanctions levelled by the West against Russia have added new distortions to supply chains, already the main villain in Macklem's inflation story.

That contradictory message — that you should expect inflation to continue to rise, not fall — isn't just coming from outside the country. Last week, Canadian banks reported a new surge in lending, pouring more money into the country's overheated economy. If fear of a future stream of increasing central bank interest rates was supposed to deter borrowers, it hasn't convinced them yet.

Not only do world markets seem to be colluding against Macklem, but the central bank itself is implicated in rising prices. Economists say the increase in rates themselves will actually lead to an increase in inflation, as the rising cost of payments on huge mortgages begins to show up in the consumer price index (CPI).

As Al Ullman, the late U.S. politician who chaired the House ways and means committee, once said in 1980, when inflation was hovering at around 13 per cent: "To depend on monetary policy to slow the economy by increasing interest rates adds to inflation because that increase goes into the cost of everything we buy."

Well-known Canadian economist Eddy Ng, the Smith Professor of Equity and Inclusion in Business at Queen's University in Kingston, Ont., said the same thing is happening again today. In fact, he said, that's the intent of rate increases.

"The conventional wisdom is to raise interest rates because that will make it more expensive for consumers and businesses to borrow, and hopefully that would stop the consumption," Ng said in a phone interview last week after the bank's rate hike.

"I think that's a fundamental misreading of the economy," he said.

Ng said the problem now is a shortage of supply — and raising borrowing costs will merely make it harder for businesses to contribute to filling those supply gaps.

The other peculiar thing about the effect of rising interest rates on mortgages, he said, is that while rising house prices are considered an increase in asset value and therefore not counted in inflation, the higher level of interest paid on those large mortgages feed straight into the CPI as part of Statistics Canada's shelter component.