Jamal Hejazi
Director, Transfer Pricing Tax
Caitlin Richer
Intermediate Technician, Transfer Pricing Tax
Published: November 03, 2023
Updated: November 03, 2023
Over the last two years, inflation has been a major headline in news due to the impact of COVID-19, geopolitical factors, and the impact of various measures implemented by all levels of government across the country meant to address the negative economic impacts of the pandemic. Before COVID-19, the issue of inflation was a topic reserved for central bankers to discuss. We often assumed that inflation would remain at the 2% due to the fact that the Bank of Canada had targeted inflation at 2% for the last 30 years, allowing the inflation rate to oscillate between 1% to 3%. This was the hallmark of the central bank, anchoring inflation in the minds of consumers and businesses alike. This was a far cry from inflation rates pre-1991 and the inflation that has ensued as a result of the COVID-19 pandemic, which today greatly exceeds 2%.
This article will highlight the current challenges that the Canadian central bank faces and analyze the new era of supply shocks and how the impact that global economic factors will have in setting inflation within specific industry settings. The Bank of Canada has one instrument at its disposal—inflation targeting—which often leads to asymmetrical impacts across the economy. When the central bank aims to move the economy towards the target inflation rate, it does so at the macroeconomic level. This approach entails some negative spillovers at the sector level of the economy, with some industries benefiting more than others. Moreover, other factors unique to industries may also contribute to higher inflation in specific sectors, even though aggregate inflation may remain at the 2% level.
The era of COVID-19 variables and inflation
Pre-COVID-19, the central bank effectively used monetary policy to meet its commitment of a 2% inflation target. When the economy overheated, the central bank raised interest rates to cool demand, which reduced prices and inflation. Central banks were adamant, and rightly so, that inflation produces no benefits in the long run and only produces short-term costs from reduced economic demand. Thus, the common thinking of the central bank was to allow inflation to fall within a 1% to 3% range to provide the flexibility to fine-tune interest rates and move the economy closer to its potential while maintaining an inflation target.
As the graph above suggests, inflation was largely in this range, except for the periods pre-1991 and post-2020, which is where we are today.
Canada's annual inflation rate 1991–2021
Is targeting inflation the right approach?
Many argue that targeting inflation by raising interest rates to reduce demand is not advisable given the current issues around affordability in Canada. The Bank of Canada has raised interest rates over 400 basis points over the last 18 months and many argue doing so only serves to hurt Canadians.
There is good economic reasoning as to why the Bank of Canada must implement a low inflation rate policy. In short, while inflation may have a positive impact on economic output in the short run, it has no benefit to stimulating economic output in the long run. Given this, it makes sense for the bank to keep targeting inflation as its cornerstone policy. Any discussions of affordability and the supply of homes for instance rests with governments and not central banks. Consequently, inflation in the long run provides us with little benefits and serves only to bring higher costs. Inflation erodes purchasing power, which has a greater impact on lower income Canadians, and only serves to raise interest rates. This can present an incorrect and incomplete picture of the true cause of inflation.
Given the detrimental spillovers of inflation in the long run, measures to combat inflation must continue in order to ensure a prosperous economy for the future.
Why inflation-targeting today is more difficult than the past 30 years
Measures to combat inflation in Canada and across the world are much different now—both during and post-COVID—than the inflation-targeting regime between 1991 and 2020.
Three key factors impacting the economy now include:
Demand issues related to economic stimulus and pent-up demand, which served to increase demand and, thus, inflation.
Supply chain issues, which serve to increase prices.
Changing demography, including a reduced labour force, that serve to cut supply and increase prices.
The central bank is well-versed in demand side issues. Increases in demand in the past have resulted in the central bank tightening its monetary policy, reducing demand and prices, allowing them to reach the 2% target. Conversely, if the Bank of Canada thought demand was too weak, it would loosen its monetary policy—while not violating the inflation band of 1% to 3%—increasing economic demand by making borrowing cheaper which increases prices.
However, supply issues will make inflation-targeting more difficult going forward. Supply chain issues in a more fractured world make the prospect of keeping inflation at 2% more daunting, although not impossible. Negative supply shocks require the central bank to keep interest rates higher for a longer period, since demand needs to fall enough to offset the price increases that result from negative supply shocks. Not surprisingly, the Bank of Canada, as well as all of the industrialized world, have had to keep interest rates elevated for many months, raising its key lending rate by over 400 basis points since March 2022. While this certainly impacted demand-led inflation, it was necessary to reduce and offset the negative impacts of adverse supply shocks on inflation. As rates rise and remain elevated for a significant period, this reduces demand more than usual to help offset the negative impact of supply shocks on inflation. This has led to greater price stability at the expense of output stability. Given rate increases take six to eight quarters to work their way through the economy, we expect output growth to deteriorate further as inflation falls.
Looking forward
At the outset of this problem, the solution against inflation is associated with government policies, as they serve an important need to reduce supply side pressures. Going forward, a global consensus is warranted to ensure that supply chain and demographic issue are rectified. Furthermore, an increase in the supply of the labour market is needed to ensure that workers are available, reducing excessive pressures on salaries. These are government policies, not policies controlled by central banks. In the long run, there are no advantages to having inflation. When excessive inflation exists, it often requires a response from the government, usually in the form of increasing supply or addressing issues that limited supply.
Contacts
The information in this publication is current as of October 2023.
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