Higher Interest Rates Producing a Predictable but Avoidable Recession

By Jim Stanford, Economist and Director, Centre for Future Work

New labour force data from Statistics Canada confirm that Canada’s economy is already slowing down sharply as a result of aggressive interest rate increases begun by the Bank of Canada in March.

 With the U.S. economy (Canada’s largest trading partner) already in technical recession (with two consecutive quarters of real GDP contraction), and monthly GDP data showing no growth since May, this new report adds to worries that Canada’s economy is heading into recession as well.

pull quote The labour force data confirm that the aggressive monetary tightening begun by the Bank of Canada in March is having a negative impact on employment and participation in Canada’s labour market.

Employment fell in July for the second consecutive month, with a cumulative loss since May of 74,000 jobs. That’s the worst decline unrelated to COVID lockdowns since the pandemic began.

 Employment is now lower than it was in March when the Bank of Canada began lifting interest rates.

 Another worrisome sign is the accelerating drop in labour force participation, which has fallen 0.7 percentage points since March. That represents the loss of 225,000 workers from the labour market, at a time when many employers still complain of a ‘labour shortage’.

 The recent upsurge in inflation was obviously not caused by labour market conditions. The Bank of Canada itself agrees it was sparked by supply chain disruptions, the global energy price shock, and changes in consumer buying patterns.

 Since inflation arises mostly from supply-side constraints, it is self-defeating to respond by chasing hundreds of thousands of workers out of the labour market. That doesn’t fix supply chain problems, it makes them worse.

 Higher interest rates also discourage investment in new capacity and supply infrastructure. This will also make the underlying cause of today’s inflation worse, not better.

 While nominal wage growth has increased, it still lags well behind current inflation. This means that average real wages (and the living standards of Canadian workers) continue to fall.

 In the 12 months to June, average real hourly wages declined by 2.7%, and are now below pre-pandemic levels.

Even central bankers acknowledge that the causes of this inflation are unique and—to some extent—temporary side effects of the pandemic. They admit that this is different from the wage–price spiral of the 1970s that neoliberal monetary policy wrestled to the ground.

AdBut after some initial hesitation, they have now invoked that textbook policy response with renewed vigour. Interest rates will be increased to reduce inflation back to the target of around two per cent in most countries, no matter what.

 Over 50 central banks around the world have increased interest rates this year, led by especially aggressive upward moves in the U.S., Canada, and Australia. The Bank of Canada has already boosted its key rate 4 times, by a combined 2.25 percentage points.

 These increases in interest rates, applied indiscriminately to all borrowers (whether making productive real investments or speculating on financial assets), will have harsh effects on the economy.

 Asset markets have been roiled by higher rates and the slowing flow of cheap credit assets: equity markets have fallen into ‘bear’ territory in most countries, and more speculative assets (like cryptocurrencies, high-yield debt, and emerging market bonds) are teetering on the verge of meltdown.

 Property prices, inflated by years of ultra-low interest rates, are also turning down sharply. While this might seem to ease the housing affordability crisis, for most buyers any savings will be offset by higher interest costs.

 The impact of higher interest rates on real spending and investment will take longer to be fully felt (likely between 12 and 18 months), but that, too, will be painfully contractionary: reducing business investment and spending on consumer durables. The latest jobs numbers indicate the contraction in the real economy is starting quickly.

 As a result of this aggressive monetary austerity, the global economy is slowing down sharply. After an encouraging rebound in 2021, global GDP growth is expected to be cut in half in 2022: from 6.1% last year to 3.2% this year. The World Bank expects this year to mark the sharpest single-year downturn in world growth in 80 years.

 Most frustrating is that this potential recession, like others caused by overzealous monetary policy in the past, is not an accident, but the outcome of deliberate policy.

 By throwing ice water over the entire macroeconomy to address inflation that has unique and more concentrated causes, the Bank of Canada’s actions will exacerbate the decline in workers’ living standards.

 Progressive movements need to reject the underlying arrangement in which permanent excess capacity—in essence, a reserve army of workers—is always available to discipline labour and control inflation, and a single, blunt policy instrument (the interest rate) is used to regulate the whole macroeconomy.

 In reality, macroeconomic policy should invoke a much broader, more flexible, and more discriminating set of tools—including fiscal policy, regulatory measures, public service provision, and even public ownership—to achieve and maintain full employment with stable inflation.

 It will take years of educating, organizing and struggle to win any of those remedies. In the meantime, however, unions and other progressive movements must simply resist the effort to make workers pay for a crisis they didn’t create. This Labour Day is a good time to start.

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