This sentiment, originally expressed in ancient Greek literature and more recently in a series of Jane Fonda workout videos, aptly captures the current view of many central banks. This includes the U.S. Federal Reserve (Fed) and Bank of Canada (BoC).
The principal goal of most central banks is price stability. This objective is often defined as an average annual rate of increase in the Consumer Price Index (CPI) of 2%. Inflation moved sharply away from this target during 2021 as economies experienced a Covid-related spike in supply bottlenecks, followed by a surge in spending. Central banks responded by aggressively raising policy interest rates in an effort to slow spending and head off an increase in wage costs otherwise likely to perpetuate the inflation cycle. Borrowing rates and mortgage costs have risen sharply.
Through a combination of weaker base effects and easing supply bottlenecks, Canadian and U.S. CPIs have recorded impressive declines over the past year. From June 2022 peaks of 9.1% and 8.1%, respectively, CPIs had fallen by April to 4.9% and 4.4%. So far so good. And yet still a long way from success. Employment growth remains strong in both countries. Wage cost inflation is far above rates compatible with a permanent return of CPI to 2%. Central bank medicine starts to bear down on growth and inflation only once policy becomes restrictive. Fed Chair Powell thinks we have reached that point Opens in a new window.. But as we all know, medicine only permanently cures the ill if you complete the prescription. The Fed and BoC will likely keep policy tight until rates of unemployment rise well above current lows. Economic hurt is on the way.
Central banks are inherently pragmatic. They recognize policy tightening comes in many forms. Recent banking stress in the U.S. will likely lead to a further tightening in lending standards. This will reduce the amount of credit available, particularly to small businesses, to invest in new equipment and to maintain current levels of payroll. Some retrenchment is likely, leading to weaker growth, higher unemployment, and a further fall in inflation.
As the opening quote highlights, Sir John Major has a particular aptitude with words. Jane Fonda is arguably pithier: “No pain, no gain,” she famously proclaimed Opens in a new window.. The U.S. and Canada appear set to experience the pain of economic recession. Through restrictive monetary policies, the Fed and BoC aim to enable each country to realize the long-term economic gain expected to derive from a return to a low-inflation environment.
