Bank of Canada governor Tiff Macklem said it’s “plausible” that higher interest rates could slow the economy faster than in the past, while also acknowledging that macroeconomic forces such as a shift in supply chain dynamics could make it harder to get inflation back to the central bank’s two per cent target.

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Tiff Macklem says elevated debt might make households more sensitive to rate hikes Back to video

“There’s certainly a case to be made that (the effect of rate increases) could be stronger than the past and the main reason for that is household indebtedness has increased considerably since the last time interest rates were this high,” Macklem told reporters following a speech hosted by the Business Council of British Columbia in Vancouver on Dec. 12.

“So, when households hold more debt, the impact higher interest rates have on servicing that debt is bigger,” Macklem said.

The remarks could colour expectations of whether the Bank of Canada will raise the benchmark interest rate again in January, or opt to stop at 4.25 per cent, which is where policymakers set the key rate last week with another outsized increase of half a percentage point.

Bay Street analysts will be looking for clues about Macklem’s thinking because the central bank dropped guidance that guaranteed future increases. Now, decisions will depend on its assessment of the data at each policy meeting. If policymakers think households are more sensitive to higher borrowing costs, they could decide that the four percentage point increase they orchestrated this year — the most aggressive series of hikes ever — will be enough to curb demand and cool inflation.

Macklem’s comments were prompted by a question about former Bank of Canada governor Stephen Poloz’s assessment in late November that Canada is more sensitive to interest rates than it was a decade ago, and that could have a bearing on the central bank’s attempts to get inflation back to its target of two per cent. “The actions that are being taken to get us there will turn out to be even more powerful than a lot of people think,” Poloz, who now serves as a special adviser at law firm Osler, Hoskin & Harcourt LLP, said at an event in Ottawa hosted by Western University’s Ivey Business School.

Poloz added that Canada has yet to feel the full brunt of this year’s hikes.

Statistics Canada reported Dec. 12 that seasonally adjusted household debt to disposable income rose to 183.3 per cent in the third quarter, one of the highest levels on record. That ratio was about 170 per cent in 2012, about 116 per cent in 2002, and about 94 per cent in the third quarter of 1992.

Higher debt levels could leave a mark on the broader economy. As borrowing costs climb, mortgage-holding Canadians use less of their pay to eat out at restaurants, purchase discretionary goods, and generally provide less stimulus to the economy in order to service these debt costs.

Macklem’s hope is that higher interest rates will deflate “excess demand” without causing a spike in unemployment, giving suppliers a chance to catch up with unfilled orders, reducing inflationary pressures in the process.

However, the governor indicated that ongoing structural changes in the economy could complicate the path back to two per cent.

In his speech, Macklem warned that some of the disinflationary forces that helped central bankers achieve price stability over the past few decades likely won’t be in play in the future. The governor pointed to shorter, less efficient supply chains; a heightened risk of geopolitical shocks such as Russia’s invasion of Ukraine; and the retirement of the baby boom generation as factors that could exert upward pressure on inflation in the years ahead.

Our monetary policy is working

Tiff Macklem

“Over the long term, it seems likely that we won’t have the same disinflationary forces that we’ve had for the past 30 years,” Macklem said. “These potential developments could make it harder to bring inflation back to the two per cent target and keep it there. But how much harder is very difficult to say.”

The governor insisted that he remains confident in the Bank of Canada’s approach of setting interest rates to keep inflation at two per cent. Still, Macklem’s willingness to acknowledge the possibility that forces beyond his control could put the target out of reach shows that policymakers face a period of chronic uncertainty.

Stephen Tapp, chief economist at the Canadian Chamber of Commerce, agreed with Macklem’s assessment. “Looking ahead, it’s possible — even likely — that slowing inflation down will be more difficult, as there will be upward price pressures on wages from retiring baby boomers and scarce labour more generally; (and) on rising trade costs from firms building more resilient trade relationships,” Tapp said.

Charles St-Arnaud, chief economist at Alberta Central, said: “This points to interest rates being persistently higher in the future than during the past 20 years for the same level of inflation. This is the new reality we are entering. It will require a period of adaption, especially since we have been used over the past decade to interest rates close to zero.”

As the central bank closes the book on monetary policy in 2022, the next year could pose a greater challenge in how these more impactful rate hikes in the past year contend with seismic structural economic shifts.

Macklem characterized the past year as one with difficult decisions and hard lessons, but maintained that the future will be “a lot better than the last three years,” which were marked by a deadly global pandemic, an epic collapse in gross domestic product, and a burst of inflation unseen in four decades.

“We want to restore price stability in the best way possible for Canadian workers and businesses,” Macklem said. “We know the adjustment is difficult, but it 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. That’s what lies ahead if we follow through.”

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