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These days, both the U.S. Federal Reserve (Fed) and the Bank of Canada (BoC), along with many other central banks in charge of monetary policy for the world’s largest economies, want higher inflation. That’s because in many cases, their inflation rates hover in the 2% or less range - perilously close to the zero, which puts outright deflation well within reach if a recession or another economic shock hits.
In today’s post I’ll explain why the Fed and the BoC are actively rooting for above-target inflation and I’ll outline the implications for borrowers who are trying to decide between fixed and variable mortgage rates.
In today’s environment, inflation moves an economy away from a central banker’s biggest fear – deflation. While central bankers are confident that they have the right monetary policy levers and tools to rein in inflation, they know that deflation is a much more cunning beast to tame. For example, the Bank of Japan (BoJ) has been trying to conquer Japanese deflation for twenty years, and it has only recently managed to stimulate a little inflation, although even the sustainability of this momentum remains an open question.
Recent fears of deflation are further exacerbated by the fact that many of the world’s central banks have already used up most of their dry powder defending their economies against the last financial crises, leaving them even more constrained than usual to fight new deflationary threats.
While it may sound counterintuitive when policy makers are charged with maintaining price stability, central bankers ideally do want some inflation in their economies - especially when mired in today’s low-growth environment where rising inflation provides a crucial buffer against deflationary risks.
If you’ve been following Fed and BoC commentary, you’ll be familiar with their ongoing guidance that rising inflation will be tolerated for as long as it takes to return their respective job markets to full health. A healthy job market includes rising labour costs, which are one of the most important drivers of inflation. Thus, the Fed and BoC’s repeated focus on healthy job creation dovetails nicely with their desire for higher inflation.
In its simplest form, the basic Keynesian theory that underpins most central-banker thinking is that gradually rising inflation causes consumers to buy now instead of waiting because they expect prices to rise in future, as opposed to deflation, which causes consumers to forego purchases because they believe prices will drop if they wait.