One of the most important ideas in central banking is that if we believe policymakers will hit their inflation targets, we’ll adjust our expectations accordingly and they won’t have to discipline us through higher interest rates. 

Like so much else, the events of the past couple of years have challenged the extent to which central banks can rely on what they call the “expectations channel.” The best example might be wage growth, which is growing at rates faster than four per cent a year, despite Bank of Canada governor Tiff Macklem’s insistence that he will return inflation to the two per cent target.  

Macklem acknowledged the debate when I interviewed him earlier this month. I didn’t publish that part of our conversation, planning to return to it at a later date. With this week’s surprisingly low inflation figures, that date has arrived.

Central banks tend to be run by people who grew up trying to prevent a repeat of the stagflation of the 1970s and 1980s. It’s received wisdom that inflation spiraled because the public had little faith that institutions would bring it under control. 

Here’s Bank of Canada deputy governor Sharon Kozicki talking about those decades in a December 2022 speech: “A key challenge at that time was that inflation expectations kept rising. Remember, this was before central banks adopted inflation targeting. This means there was no target to anchor expected inflation. As a result, households and businesses saw no reason to believe that prices wouldn’t simply continue to climb at a rapid pace. They then baked this assumption into their decisions and plans. As a result, even as the economy cooled, inflation remained stubbornly high.” 

That’s one of the reasons central banks around the world raised interest rates so aggressively when inflation spiked after the COVID-19 pandemic. The difference between a temporary price shock and runaway inflation is confidence among economic actors that higher costs won’t last. 

Central bankers insist their credibility has helped avoid a repeat of the 1970s. “One of the great developments over the last couple of years is even though we did have a period of very high inflation, long-term inflation expectations really stayed [anchored] through that period,” Bill Dudley, the former head of the Federal Reserve Bank of New York, said recently on the “Masters in Business” podcast. 

Macklem concurs. “We’ve been able to achieve a considerable deceleration of inflation without creating big recessions in our economies,” he said in our interview. “We’re not out of the woods yet, but I think it does demonstrate [our] focus on moving with determination to keep those long-inflation expectations well anchored has been really valuable.”

As bad as it might feel, the aftermath of the post-pandemic inflation shock has been nothing like what people endured after the oil shock of the 1970s. I could post a chart, but I’d rather share the observation a reader recently shared with me on what it was like to be a first-time homebuyer in 1981: he started with a mortgage of 10.5 per cent; facing a second mortgage of 21 per cent, he instead borrowed from his grandmother at 16 per cent; he filled his home with second-hand furniture, drove as little as possible, ate at his desk, and started what today would be called a side hustle.

If you think Tiff Macklem is ruining your life, you might want to give a thought to what it would be like if his generation of economists hadn’t spent so much time trying to figure out what went wrong in the 1970s. “It saddens me that young people don’t realize that [mortgage] rates of 5 or 6 per cent are a steal relative to their parents’ generation,” the reader wrote in an email. “But, times change and somehow things generally work out in the end.”  

The latest inflation numbers suggest things are indeed working out. The consumer price index increased 2.9 per cent in January from a year earlier, compared with 3.4 per cent in December. That’s still faster than the Bank of Canada would like, but it is back in the central bank’s comfort zone of one per cent to three per cent for only the second time since the spring of 2021. If the trend holds, policymakers could potentially start cutting interest rates before the middle of the year and tame inflation without driving the economy into recession. Another generation of new homebuyers will be spared double-digit interest rates. 

Still, the post-mortems of this immaculate disinflation should include an assessment of whether expectations work the way central bankers schooled on pre-pandemic conditions think they do. 

The Bank of Canada’s latest quarterly survey of consumers reported that respondents expected inflation of about 2.6 per cent in five years. But those surveyed said they thought inflation still would be almost five per cent in a year, and almost four per cent in two years. This suggests the central bank’s power of persuasion might be weaker than is generally assumed. 

Does that matter? It might. If the behaviour of households and businesses is unresponsive to a central bank’s promises to get inflation under control, then policymakers will need to set interest rates higher to hit their targets. 

The disconnect between shorter-term and longer-term expectations has the governor of the Bank of Canada thinking.

“Short-run expectations have stayed elevated. That could be factoring into people’s decisions,” Macklem said. “It is hard to measure precisely, and I would say there is some debate about that. That is one of the things we’re looking at, because we do think it could have some effect.”

The problem could be that households tend to react to eye-poppers such as the prices of gasoline, food and rent—not the consumer price index, which is what the Bank of Canada uses as a guide because it is the best representation we have of the cost of everything. 

Household consumption has been dropping. What people do could be a better indicator of their expectations than how they respond to a survey. “That looks like the behaviour of people who are anticipating low inflation going forward, or a recession,” Simon Fraser University economics professor Luba Petersen said in an interview.

By their actions, if not their words, the country’s households may be sending the Bank of Canada the message that what they expect is an interest rate cut—and soon. 

Kevin Carmichael is The Logic’s economics columnist and editor-at-large. He has spent more than two decades covering economics, business and finance for outlets including Bloomberg News, The Globe and Mail and the Financial Post, where he also served as editor-in-chief.