By raising interest rates, the governor of the Bank of Canada has made a mistake. He got an easy question wrong. Is the economy expanding or contracting? He called it expansion, meaning output is growing, putting upward pressure on prices. The increase of 0.25 per cent in the overnight lending rate of the bank signals the beginning of a cycle of increases that will push all interest rates in Canada up over the next 18 months by as much as two percentage points.
World economic signs signal deflation meaning slower output, and faltering employment.
Inflation calls for interest rate increases, and government spending cuts. Deflation means no interest rate hikes, and government spending increases.
Inflationary times have dominated Canadian politics since the mid-1970s. Business groups banded together to push governments into ill-conceived wars on inflation, deficit reduction targets, and adventures in free trade, all designed to reduce not just government spending, but the role of democratic institutions in daily life. Current counsel emanating from business leaders is for governments to cut spending, and for the Bank of Canada to hike interest rates, not just today but also at the next opportunity in July, and subsequently.
Recent economic numbers look positive for Canada, a first quarter growth of 1.5 per cent, which translates into 6.1 per cent on an annual basis. A closer look reveal a different story. Business economist David Rosenberg point out that overall, GDP is no higher today than it was three years ago. Real unemployment is at 12 per cent, job creation is disappointing, and salary increases (at two percent) are weak says the Globe and Mail commentator.
Steelworkers economist Erin Weir shows that the recent upturn is linked to companies restoring inventories, and household construction. A reversal in the housing market, and weaker consumer spending could turn the economy around quickly. Paul Tulloch adds that consumer spending increases are funded by domestic debt increases.
Increases in interest rates could turn the whole picture around. Economic policymakers have to think about how to prevent private spending from spiraling downwards, taking companies into bankruptcy, banks into receivership, and forcing families out of their houses. Price increases represent nothing like this type of problem.
In a deflationary economic climate the challenges are not the same as in an inflationary era. Deflation requires public sector leadership and co-ordination among governments: it means expanding the role of government in the economy, as regulator, spender, investor, and champion of social equality.
As a result of the economic downturn of 2008-09, governments have gone sharply into deficit. This is the “aftershock” effect of the actions taken to prevent a recession from becoming a depression.
Making deficit reduction the new priority (as the OECD is arguing for instance) misses an essential point. Government deficits pump money into the private sector. Reducing public sector deficits takes money out of the private sector, promoting another downturn. When governments and central banks reverse track by cutting back and raising interest rates, they add to deflationary pressures. Banks cut back on loans, and employment plummets. Deflation pushes businesses into bankruptcy, and puts workers out of their houses. Reducing government spending, and increasing interest rates could make things worse for Canadian families, very quickly.
Overhanging the Canadian economy like other industrialized economies is consumer and business debt. Increasing interest rates raises the cost of servicing the debt, and drives consumer and business spending down. The additional money spent on interest payments on the debt is not available for spending on goods and services. In the case of mortgage debt, interest rate hikes shrink family budgets.
Adding to deflationary pressures in Canada is the over 20 per cent appreciation of the Canadian dollar. This gives foreign producers an advantage in the Canadian market and in overseas markets; it puts Canadian producers at a disadvantage at home, and abroad.
Making the inflation or deflation call is not just a question of knowing the difference between up and down. It is also about deciding whether or not to heed corporate advice. By raising interest rates, the governor of the Bank of Canada is saying big business does know best.