E-sight Weekly June 27: Understanding the Inflation Shock

The main economic release last week was the Canadian Price Index for May, which showed Canadian inflation rose to 7.7 per cent, the fastest pace since 1983. The biggest contributors were gasoline, hotels, restaurants, food prices, shelter main contributors. Gasoline was a particular shocker, up 48.0 per cent year-over-year, while food prices were up 8.8 per cent. Excluding food and energy prices, core inflation was very hot at 5.2 per cent.

With inflation being top of mind, lets answer many of the questions I have been getting about the current inflation environment.

What caused inflation shock?

We can break down the current inflation shock into various stages.

1.   Supply chain disruptions during the pandemic were the start of the inflationary impulse. Just-in-time inventory systems broken down. This led to inadequate supply that bid up prices. A great example of this was the lack of computer chips for the production of new cars that led to a surge in used car prices. 

2.   Then as health risks stabilized, demand accelerated as recovery started and then built up steam. Rising demand at a time of constrained supply pushed prices higher.

3.   Next came the COVID variants that created additional supply chain problems and the war in Ukraine that cause a major supply shock – particular for energy and food prices.

4.   As inflation became embedded in consumer psychology, businesses found they had pricing power and could increase margins without seeing a drop in sales. The large pool of consumer savings (discussed below facilitated this).

How much of current inflation is coming from supply problems and how much is coming from demand?

A key issue for monetary policy is how much of inflation is coming from domestic demand, which can be affected by tighter monetary policy, and how much is the product of supply chain disruptions and global labour shortages, which cannot be affected by domestic policy. Disaggregating these two forces is very difficult, but a very recent paper by the Federal Reserve of San Francisco provides a US estimate. It argues that only about a third of the current recent elevated inflation is the product of demand factors. 

If demand is only driving roughly one-third of the recent inflation, there are some implications for monetary policy. Raising rates will dampen inflation, but it will have a limited effect unless the central bank is prepared to deeply depress demand causing a recession – which is not appropriate if demand is not the primary problem. This is a huge challenge. However, the central bank likely has to talk tough even if it is not going to take rates to punitively high levels in order to help anchor inflation expectations. 

In the April 2022 Bank of Canada Business Conditions Survey 65% of businesses said they expect inflation to be above 3% over the next two years, while 40% expect it to be above 4%. The reasons given were supply chain issues, commodity prices (including energy, building materials and food), and labour costs. 

This is a problem for the Bank of Canada. If businesses expect inflation to be above their 1-to-3% target band and they all use that expectation in their contracts with suppliers, customers and workers – it becomes a self-fulfilling prophecy. This is why having inflation expectations anchored is so incredibly important to the central bank. Now that inflation expectations have become unanchored relative to the target, the Bank is having to re-establish its credibility as an inflation fighter.

Given that the a large share of inflation is coming from the supply side, the Bank of Canada should limit for high it takes rates. It should raise the overnight rate to at least neutral, which is around 3.00%, and this should cool down the interest rate sensitive segments of the Canadian economy – like residential real estate. However, it cannot address supply side inflation and putting the Canadian economy into a demand contraction recession is unwarranted. Moreover, the Bank of Canada will be helped by the rebalancing of monetary policy in the United States. The US economy is arguably overheating more than the Canadian economy and the US Federal Reserve is hiking rates to slowdown US growth. This will weaken Canadian exports and Canadian growth. In other words, the US Federal Reserve will do some of the work for the Bank of Canada.

Wages are not causing inflation…yet

Wages rose 3.9 per cent year-over-year in May. However, 0.8 percentage points of that can be attributed to shift in occupation shift in hiring. There are geographic and skill or occupational shortages for workers. So far wages are not driving inflation.

However, central banks fear that exceptionally tight labour markets will lead to further wage pressures. Often wage pressures increase with a lag after inflation accelerates as workers feel the pain of increased living costs. If wages increase, firms might try to pass higher cost onto consumers. If they do, this can become a vicious inflationary spiral that is hard to break. This is something central banks want to avoid. 

The risk is real. The unemployment rate in May was 5.1 per cent – a record low based on current way of measuring it. There were 890,000 unfilled jobs in Canada in the first quarter of 2022. Almost a third of all employers are reporting labour shortages. The majority of employers are expecting to be increasing wages at a faster rate in the coming year.

If wages are not keeping up with inflation, how are consumers still spending?

The latest retail spending numbers show consumers still have wallets open despite wage growth running close to half the pace of inflation. How is this possible?

In the decade prior to the pandemic, household disposable income rose at 3.8 per cent per annum. However, when the pandemic hit, government transfers soared and tax payments, with the result that household disposable income rose 8.9 per cent in 2020 and then edged up 3.0 per cent in 2021 – an average of 6 per cent per annum over the period of government lockdowns. 

So, we have a terrible recession. Labour compensation fell 1.1%. But, Household income soared and this supported massive savings. Prior to the pandemic, Canadian households in aggregate saved about $25-$35 billion a year. Over 2020 and 2021, they saved $360 billion – partly due to government transfers but largely because they could not spend money on things they traditionally buy – like eating out, going on vacations, going to movies, and other things inaccessible during the pandemic. This massive pool of savings helped to fuel the recovery and it has been inflationary. 

I think there is compelling evidence that governments delivered excessive stimulus during the pandemic (this might be unfair given that it is being judged with hindsight but even some of the measures during the pandemic seemed politically opportunistic and/or excessive), particularly given the reduction in spending that was going to occur on the part of households. 

Some are now blaming businesses for inflation by focusing on the profits being generated, and there is truth to this – some businesses have expanded margins. But, you can also ask what is generating the profits. They are not coming from thin air. They are coming from consumer spending. Where is the money coming from? The answer is the income growth of households and profit growth of businesses. Inflation is absorbing the excess money.

Did the Bank of Canada cause inflation by printing money?

Prior to the pandemic, money supply (using the M2 broad definition) was averaging growth of around 6.5 per cent a year. Then the crisis hit and massive stimulus was deployed, with the result that money supply growth surged to peak at 19.4 per cent year-over-year in February 2021 – this exceeded the 14.8 per cent peak that occurred during the 2008/09 Financial Crisis and the financial system did not face the same strains this time around. The surge in money ran the risk of fueling inflation as it flowed into the economy (i.e. velocity of money has increased but is still far from normal). However, it would only factor into the demand-side of inflation, not the supply-side inflation. 

Bank of Canada’s Quantitative Easing (QE) Program was the means of raising the money supply

Pre-pandemic Bank of Canada held $119 billion in securities, of which roughly $80 billion were Government of Canada (GoC) bonds.

At its peak of QE buying in February 2021, the Bank held $577 billion in securities (net increase of $458 billion) of which $332.3 billion were GoC bonds. In effect, the Bank financed virtually the entire value of the GoC $327.7 billion deficit in FY 2020-21. 

At the end of March 31 2022, the Bank held just under $500 billion in securities but their GoC bond holders were $389 billion.

The Bank is now pursuing quantitative tightening, selling bonds and the pace of money supply growth has retreated to around 6 per cent – so back to a more normal pace. It is like to slow further as policy is tightened as part of an effort to rein in inflation.

Critics have attacked the Bank for printing money and ignoring inflation, which is unfair. The Bank had to provide support to the economy and the financial system during the pandemic. With the overnight rate starting at only 1.75%, QE was likely necessary to provide additional monetary stimulus. And, the early stages of the acceleration of inflation did not come from domestic sources. Most economists thought the supply chain disruptions would be temporary/transitory. 

However, the Bank was too complacent about the sustained strength of demand growth and its potential inflationary consequences. I think it was evident by last Fall that the economic recovery was strong, that labour markets were tightening, that demand was going to be sustained and that price pressures warranted at least starting to rebalance monetary policy. Indeed, headline inflation was over 4 per cent and core inflation was over 3 per cent in September 2021 and was trending rapidly higher, but it took until March 2022 for the Bank of Canada to deliver its first hike. 

I think the Bank might have gotten trapped by their forward guidance. They were promising financial markets that they would not raise rates until the second half of this year. They didn’t want to deviate from this despite the evidence of prices rising. I also think they kept hoping that the inflation from the supply chains would abate. In January 2022, they threw in the towel and ended forward guidance. In March, they hiked a quarter point. In April, they hiked half a point. In June, they hiked half a point. Markets expect a three quarters of a percentage point increase on July 13th taking the overnight rate to 2.25 per cent.

There have been attacks on the competency and the independence of the Bank of Canada. In my opinion, this is incredibility unfair. Much of the recent inflation has come from the supply side, which is beyond the bank’s control. I think it is fair to argue that as demand remained strong, it waited too long to start tightening policy, but that isn’t a matter of competency. It is a judgement call that the Bank got wrong. It happens. 

Where will inflation go from here?

Inflation is expected to peak this summer and is not expected to reach double digits. The central bank rate hikes are expected to have an impact on interest rate sensitive segments of the economy quite quickly. Indeed, Canadian residential real estate is already cooling down rapidly, and a price correction is highly likely. A lot of consumer spending is tied to housing related purchases, and this will show up in retail spending. The economy should also experience slower economic growth in the coming quarters. Exports will soften as US economic growth weakens and business investment will be curtailed as firms become more conservative with their capital spending plans. Recession talk will be rampant, and this will weigh on consumer and business confidence as well as spending. All of this should lead demand-side price pressures to gradually wane. The supply-side is more challenging to predict. China’s lockdowns have passed and the initial shock of the war in Ukraine has occurred. This should allow supply chain pressures to diminish. Slowing global growth could also take pressure off global supply chains.  This doesn’t mean that the current inflation shock will disappear quickly, but it should peak and then gradually diminish over the next couple of years. There is another scenario. One where inflation goes away quickly, but that is one where there is a recession. An economic contraction deals with inflation fast, as the drop in demand causes firms to go from raising prices to cutting prices.

Categories: Canadian Inflation, E-Sight, Economics

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