Oil Prices and Bank of Canada Credibility

Scotiabank warns that persistently high oil prices could de-anchor Bank of Canada inflation expectations, necessitating aggressive rate hikes and deeper economic slowdowns to restore credibility.

Key Takeaways

• 1.Central bank credibility in Canada has not fully recovered to pre-pandemic levels, making current inflation expectations fragile and sensitive to shocks.
• 2.Persistently high oil prices ($100/bbl through 2027) could de-anchor expectations, pushing CPI inflation up to 2pp above the baseline.
• 3.A loss of credibility significantly increases the cost of disinflation, requiring an additional 140bps in rate hikes and resulting in deeper economic slowdowns.

Table of Contents

• Could Oil Prices Test the Credibility of the Bank of Canada?
• WHERE DOES THE BOC CREDIBILITY STAND?
• WHAT COULD GO WRONG?
• ALTERNATIVE SCENARIO: PERSISTENTLY ELEVATED OIL PRICES AND SUPPLY CONSTRAINTS WITH UNANCHORED EXPECTATIONS
• LOST CREDIBILITY = MORE PERSISTENT INFLATION, DEEPER ECONOMIC DOWNTURN
• THE COST OF DISINFLATION RISES SHARPLY
• BOTTOM LINE
• APPENDIX: PHILLIPS CURVE WITH ENDOGENOUS CREDIBILITY

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