Inflation and the COVID-19 pandemic

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. 

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.