Persistent inflation, not recession, 'the greater risk' as BoC looks to 2023

What to expect in the fight against inflation

Governor of the Bank of Canada Tiff Macklem speaks during a lunch by the Business Council of British Columbia in downtown Vancouver, Monday, December 12, 2022.  THE CANADIAN PRESS/Jonathan Hayward
Bank of Canada Governor Tiff Macklem says the top priority is to bring inflation back to its 2 per cent target. (THE CANADIAN PRESS/Jonathan Hayward)

Bank of Canada governor Tiff Macklem has his sights squarely on getting inflation back to the sweet spot of two per cent, but hitting that target is going to require a delicate balancing act.

"We are trying to balance the risks of over and under-tightening monetary policy," Macklem said in his end-of-year speech delivered in December.

"If we raise rates too much, we could drive the economy into an unnecessarily painful recession and undershoot the inflation target. If we don't raise them enough, inflation will remain elevated, and households and businesses will come to expect persistently high inflation."

While Macklem is aiming for that so-called soft landing, he also made it clear which option he prefers in the event that hot inflation persists and a potential recession looms.

"With inflation running well above target, this is the greater risk," he said.

"If high inflation sticks, much higher interest rates will be required to restore price stability, and the economy will have to slow even more sharply."

2022: The year of inflation

While the end of 2021 was when inflation first reared its head, 2022 was the year it exploded onto the scene.

The Consumer Price Index (CPI) reached highs not seen in nearly four decades, hitting what appears to be a peak of 8.1 per cent annually in June. Energy prices soared throughout the year, as Russia's invasion of Ukraine led to high commodity prices. Hotel and airline prices skyrocketed as many Canadians jumped at the chance to travel for the first time since the COVID-19 pandemic hit. While the supply chain issues that wreaked havoc through the pandemic largely subsided, there were still challenges that cropped up throughout the year.

Canadians especially felt the impact of inflation at the grocery store. Food prices have hit highs not seen in 41 years and have remained stubbornly high. Shelter costs have also been on the rise amid increasing interest rates. Mortgage interest costs jumped at the fastest rate since 1983 in November, and rental rates have also soared. According to, the average listed rent for all types of units in Canada increased 12.4 per cent on an annual basis, hitting a record high of $2,024.

In response to soaring inflation, the Bank of Canada has moved to aggressively hike interest rates. The central bank increased its benchmark rate by 400 basis points in 2022, the most in any year on record. While the Bank has signalled that the tightening cycle may be winding down as the economy shows signs of slowing, November's CPI data have left the door open for further rate hikes.

"Inflation forecasts were nowhere near high enough in 2022, and there's no reason to believe they'll be materially better in 2023. There's more risk of a high-side surprise (next year)," BMO Capital Markets macro strategist Benjamin Reitzes said in a 2023 preview note.

There is also concern that inflation may persist as the forces that previously helped keep prices lower – such as lower-cost global supply chains and a boom in the working population – hit challenges.

"In the future, it seems likely that supply chains will be shorter, more diversified and more resilient. Trade will likely narrow to more trusted partners," Macklem said in his December speech.

"These changes will increase resilience but at the cost of efficiency. And through this adjustment, production costs could rise, increasing price pressures."

That may make Macklem's job of hitting that two per cent target even more difficult, although he says "how much harder is very difficult to say."

Recession on the rise

Now, economists are looking at the impact of the aggressive rate hikes implemented by central banks around the world. Many expect a recession.

"We continue to expect the world to slip into recession in 2023 as the effects of high inflation and rising interest rates are felt," Capital Economics chief global economist Jennifer McKeown said, adding that Canada's recession should be moderate and allow the Bank to start loosening policy in 2023.

"The consolation is that inflation now seems to be receding, which should encourage central banks to take their feet off the brakes and allow a recovery to begin late next year."

However, McKeown says that if the Canadian labour market weakens more than expected, the elevated household debt levels in Canada could trigger the start of a deleveraging cycle similar to that seen in the United States in the 2000s.

"As affordability in the housing market is the worst in decades, house prices would be even more vulnerable in that scenario and Canada would face a much deeper recession," McKeown said.

At the same time, as Macklem has hinted, a recession may be a necessary cost to tame inflation.

"The only reason why we are even talking about a recession is because of raging inflation and the harsh medicine required to quell it. Monetary policy ultimately always works, and this is clearly a policy-induced slowdown," BMO chief economist Douglas Porter said in a note to clients.

"The best news for the economy and financial markets would be if that policy works fairly quickly and inflation recedes faster than expected, which would significantly raise the odds of our more benign scenario—and we should have a good read on that front by the spring."

Macklem says the adjustments "will be worth it."

"Our monetary policy is working, and once we all get through this adjustment, our economy can grow healthily with low inflation," Macklem said in his final speech of the year.

"That's what lies ahead if we follow through."

Alicja Siekierska is a senior reporter at Yahoo Finance Canada. Follow her on Twitter @alicjawithaj.

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