Rate Hikes or Not? Bank of Canada has a 3rd Option to Tame Inflation

Introduction

Bank of Canada and Federal Government are stuck at Rock & Hard place. What does it mean? it means, if they increase the interest rates, it will tank the ‘already struggling’ economy and if they dont, the inflation will continue to shoot up. Is there a 3rd option? well, I think there is, and we will talk about it in this blog.

Rampant Inflation

Inflation is running hot across the globe, not only in Canada, and it has various reasons, for example, global supply chain disruptions and government interventions in the free market by imposing lock downs and injecting trillions of dollars in the form of stimulus support which ended up increasing the money supply. This enormous money supply ended up chasing same amount of good & services that existed prior to this stimulus injection, resulting in driving prices up, simple demand & supply rule.

Monetary Policy Creates Inequality

More importantly, it created wealth gap and inequality by giving more buying power to rich and push middle class more towards the poverty line by imposing inflation (hidden) tax. The rock bottom interest rates makes debt dirt cheap, drove the asset prices up.?

The housing market in?Canada has gone up 27% YoY across the country with Vancouver and Greater Toronto Area pushing Canadians out in the suburbs when these cities become unaffordable.?

Canada’s Debt Bubble

With the rising debt levels, Canadians become one of the highly indebted nation in the world, and federal government’s debt to gdp ratio hit 130%, the risk of getting default on its own sovereign debt is much higher. With such huge pile of debt, Bank of Canada is reluctant to raise the interest rates, as not only it will collapse the economy, but also make debt more expensive. Not only households will struggle to pay the interest payments on their mortgages but federal government’s risk of getting default will be even higher.

So what are the options?

So Bank of Canada and Federal government work in full harmony, dont be fool to think they dont. So what choices do they have?

1. Raise the rates? Risk of getting default on debt, leads to economic collapse.
2. Keep the rates as is? Inflation will continue to rise

Or they have a 3rd option, which they have tried in the past, i.e. Price Controls.

Introducing Price Controls

In 1975, when inflation, as per official figures, hits almost 12%, Papa Trudeau’s government implemented price and wage controls by introducing Anti Inflation Act in the parliament which became a law. Among its many controls, it limited pay increases for federal public employees and those in companies with more than 500 employees to 10 per cent in the first year, 8 per cent the next, and 6 per cent thereafter. The price and wage controls were enforced until 1978, and the act was repealed in 1979. A similar program aimed only at the public sector was introduced in 1982

Why Governments choose this option?

The number 1 priority of a politician is to be re-elected. In an inflationary times, when prices of groceries, gas, rent, medicine etc are going up so often that a common person is ready to take the street, the politicians takes the path of least resistance. If they opt for hiking rates, which will potentially collapse the economy and their chance of being re-elected. if they opt to keep the rates as is, inflation will kill the common man’s purchasing power and politicians will have ZERO chance of being re-elected. So they opt for path of least resistance i.e. Price Controls.

How effective it was?

In 1975, the inflation was close to 12%, and interest rate was around 8%. When Trudeau’s government implemented price controls, it pulled the inflation rate down to 6%. But soon the price control lifted up, the inflation went vertically up to almost 13%. Then the only way to pull the inflation was to raise the rates above the inflation, which took the overnight rate to almost 20%. That finally broke the back of inflation.

Price Controls Impacts

As we learnt from history, price control policy was able to pull the inflation down for a short period of time but it comes at serious cost. Some of the impacts are mentioned below.?

1. Exacerbate Supply Shortages - I won’t produce more if my profits are slammed
2. Reduce Quality - I will only produce cheap products to keep my profits healthy
3. Inflation Explosion - Once Price Controls are lifted

But the biggest impact was, as soon as the price controls are removed, it shot up the inflation even higher than what we saw when we implemented price control at the first place. The reason is, it is an artificial way to control prices. Whenever government intervene in the free market economy, the results are never positive, it does more damage than any good as we observed.

Conclusion

I am not certain if Bank of Canada and/or Federal Government will choose this option but there is a good chance they would do it. If inflation rate keeps at is current level i.e. 5% which Bank of Canada told us it will remain for the time of 2022, the rate hikes has to be above 5% to tame the inflation. Or, price controls are most likely next.