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.