Shocks can force Bank of Canada to hike rates even when economy weak, says deputy
Supply-side shocks that can simultaneously drive up prices and slow the economy are complicating the Bank of Canada ‘s fight against inflation, but the central bank has no intention abandoning its two per cent inflation target.
“The world has changed a lot over the past five years,” Sharon Kozicki , deputy governor of the Bank of Canada, said during a speech in Oslo on Monday, noting that, in the past, it was a strong economy that tended to push inflation above the central bank’s two per cent target.
In recent years, however, shocks such as the global COVID-19 pandemic and supply chain squeezes for components such as computer chips have become drivers of inflation as the factors affecting the availability of goods and services ripple through the economy.
The inflation rate rose to eight per cent in 2022 — its highest level in 40 years — after the shock of the COVID-19 pandemic and stimulus that followed.
And though it was brought back to target after a series of interest rates hikes, some Canadians are still struggling with a higher cost of living. Then U.S. tariffs hit, and workers in the most-affected sectors started to worry about losing their jobs.
“We know that many Canadians feel they’ve been hit by one shock after another, with no time to find their footing,” she said.
In addition to the trade tensions, the Bank of Canada must consider a bevy of factors such as the impact of artificial intelligence , geopolitical tensions and an aging population, which present challenges to stimulating economic activity while keeping inflation in check at around two per cent.
“These forces mostly affect the supply side of the economy,” Kozicki said, pointing to additional factors such as more frequent extreme weather events that affect production costs, the efficient use of capital and labour and, ultimately, the availability of goods and services.
These considerations are likely to be front and centre when the Bank of Canada renews its joint agreement with Ottawa later this year that governs how the Bank of Canada sets interest rates to support the economy and keep inflation in check.
“It’s the Bank’s responsibility to ensure low and stable inflation in any circumstance. Revisiting our framework gives us a chance to assess whether we are well equipped for the challenges of the future,” Kozicki said. “And since our last renewal, supply-side developments have become more important for inflation.”
One thing that isn’t likely to be on the table is the central bank’s target inflation rate of between one and three per cent, she said, adding that a 25-year track record has established that as what Canadians expect.
“We’re confident two per cent is still the best target for Canada,” she said.
Recent shocks, however, have challenged how the central bank moves to control inflation. Raising interest rates to control inflation tends to weaken the economy further, while lowering rates can shore up the economy but won’t help bring inflation back to target, Kozicki said.
“Understandably, Canadians don’t particularly like either of these options,” she said. “Many people may find it surprising or counterintuitive that, at times, monetary policy needs to be tightened even when the economy is weak. Yet that is exactly the difficult trade-off we sometimes face.”
Shocks to the economy aren’t always as large or deep as a worldwide health crisis. Even the global shortage of computer chips several few years ago weighed on the production of goods and it added to costs for a wide variety of products, she said.
But while some supply-side shocks are temporary, others involve structural change and a transformation that can permanently alter the amount an economy can produce without generating inflation.
“It can also change the overall makeup of the economy,” she said, adding that Canada is living through a period of structural change including the impact of AI and a dramatic shift in U.S. trade policy that is rewiring global trade and Canada’s relationship with its largest trading partner.
“These drivers of structural change could affect the types of goods and services we produce, the efficiency of production, the types of skills workers need and the productivity of workers,” she said.
Kozicki said a consequence of U.S. tariffs imposed last spring is that Canadian exports are roughly five per cent lower than before President Donald Trump was re-elected in 2024, a decline that has weakened the economy.
But a key challenge for central bankers looking to stimulate the economy while controlling inflation is to determine how much weakened activity reflects lost efficiency associated with structural change and how much points to a shock with persistent but transitory impacts, she said.
To help address such challenges in a timely way, the Bank of Canada is looking at non-traditional data such credit and debit card transactions, retail payments, and passenger and freight traffic at the Canada–U.S. border.
The central bank will also lean on businesses surveys it already does to help assess how persistent the impact of supply shocks may be. One such survey, the Business Leaders’ Pulse, has been invaluable for tracking shifts in expectations about how long trade tensions could last and how those shifts affect firms’ willingness to pass higher costs on to their customers, she said.
“Overall, intelligence gathering helps us spot trends before they show up in the data, and it can give us more detailed insights. This is particularly helpful in uncertain and rapidly changing situations,” Kozicki said.
“The right choice won’t always be evident. But that’s why we’re working to establish the right guardrails and to improve our diagnostic tools. Maintaining transparency and clarity in our communication will also be critical.”
Email: bshecter@postmedia.com