The inflation problem: How did we get here, and how will we get out?
Inflation continues to top the list of consumers’ worries, as prices for items in all categories creep up (Dreamstime)
Earlier this fall, the supply chain gremlins came for the chickens.
After months of jarring disruptions in the shipment of a wide range of goods from lumber to semiconductors, Canadian restaurants found themselves scrambling to source ingredients as basic as chicken wings, which, as some foodies may know, were popularized by a Buffalo, N.Y., restaurateur who realized that deep-fried wings with sauce made excellent bar fare. According to the CBC, year-over-year wholesale chicken wing prices in August had jumped a staggering 14 per cent. “It’s been a huge challenge getting chicken for some fast food restaurants,” observes Simon Gaudreault, vice-president of national research for the Canadian Federation of Independent Business (CFIB).
Finding wings was only the tip of the problem facing small- and medium-sized firms as they tried to navigate around the shoals of the pandemic, he adds. Labour shortages have become chronic. Energy and food prices have risen, and demand has been all over the map, for reasons that are perfectly obvious—including rolling lockdowns and hesitant consumers.
“Our business barometer has been tracking price plans and wage plans on a monthly basis since 2009,” says Gaudreault. “I would say, mostly since the start of 2021, we’ve seen prices reach levels that we haven’t seen before. In the winter and the beginning of the spring of 2021, we entered a territory where price increases and wage increases were really in new grounds.”
Exactly 30 years after the Bank of Canada moved to stabilize inflation by orienting its policy rate-setting decisions to a target range of one to three per cent, the prices of a wide variety of goods have shot up in the past year, from homes and condos to renovations, grocery bills, gasoline and all sorts of manufactured goods that rely on components made in Asia, which is to say almost everything.
Early last fall, Statistics Canada reported that the September consumer price index (CPI) had hit 4.4 per cent compared to the same period a year earlier, levels not seen since the early 2000s. (There were, however, two months in 2020 that saw deflation, an equally unusual phenomenon.) The figures varied significantly by region, from 6.3 per cent in P.E.I. to just 2.9 per cent in Saskatchewan, with energy prices contributing significantly across the board. The national averages, moreover, represented a steady climb in the monthly CPI rates since the beginning of 2021. “The very things that are driving inflation now are responding to 2020’s first and second waves of the pandemic,” says economist and policy advisor Armine Yalnizyan. “This isn’t normal inflation; this is supply shock inflation.” By comparison, she adds, inflation in 2020 hovered between 0.5 per cent and one per cent, reflecting the widespread demand destruction and job loss, especially among women, that marked the first half year of the pandemic.
“What is so unique about this [period] is that it’s the greatest supply side shock since the 1970s.”
Economists though are quick to point out that monthly CPI rates are calculated as a comparison to the same month in the previous year. In other words, the spikes we’ve seen this year reflect growth relative to an especially flat 2020. Still, most economists acknowledge that this year’s inflation figures aren’t just a mathematical quirk, but rather reflect, albeit incompletely, a chaotic global economy that continues to battle COVID-19 on a range of fronts. For example, commodity and energy prices have risen sharply since the beginning of the pandemic (while oil prices actually dropped when lockdowns were imposed). Many, in fact, wonder whether the recent inflation trends are cyclical and therefore transitory, or actually suggest a structural reordering that requires decision-makers to begin rethinking a library’s worth of assumptions and policies, some of them dating back decades. “This is pandemic economics,” says Yalnizyan. “The regular rules may not apply.”
“For the past 40 or 50 years, we’ve tended to view the economy through a demand-side lens,” adds Frances Donald, global chief economist for Manulife Investment Management. “What is so unique about this [period] is that it’s the greatest supply side shock since the 1970s.”
From the Great Depression to the early 1970s, Keynesian economics prevailed in most industrialized economies, as governments used spending, deficits and full-employment goals to stoke economic growth. The postwar baby boom drove consumption across the board, but the party began to break up in the late 1960s, when unemployment started to climb. Then came the OPEC oil embargo of 1973, which triggered shortages and quadrupled the cost of gasoline at the pump. By the mid-1970s, inflation had topped 10 per cent in Canada, and then-prime minister Pierre Trudeau imposed wage and price controls. Economists coined a term to describe the malaise of that period: “stagflation”—rising prices but slow growth. (Yalnizyan maintains that the current economic environment is not at all like the stagflation of the 1970s.)
Inflation continued to press upwards, eroding spending power and retirement savings. In 1979, the U.S. inflation rate had soared to 14 per cent, prompting an unprecedented move by Paul Volcker, the towering chairman of the U.S. Federal Reserve. As a history of that period published by the St. Louis Federal Reserve Bank recounts, “Volcker, in office only two months, took the radical step of switching Fed policy from targeting interest rates to targeting the money supply.” The prime lending rate topped 20 per cent, countless businesses collapsed and hundreds of thousands of people lost their jobs.
It was a huge gamble, but Volcker broke the back of stagflation and ushered in an era in which monetary policy à la Milton Friedman—focused on maintaining low inflation through control of the money supply—ruled the roost. A couple of per cent was needed to grease the wheels of the economy and provide some buffer against the risk of deflation, but a three per cent upside limit would keep wages and borrowing costs in check.
Then-Bank of Canada governor John Crow moved to eradicate inflation in 1990 on the heels of a crippling downturn, a collapse in the real estate market and the loss of tens of thousands of middle-management positions. His more extreme goal—zero per cent—yielded to the more politically palatable one to three per cent range. Canada’s inflation-rate policy has held steady ever since, through a range of crises, including the 2000 dot-com bust, the aftermath of 9/11, the 2007 collapse of Canada’s $32-billion asset-backed commercial paper market, the 2008 global financial crisis and, finally, the 2009 recession, considered the worst downturn since the 1930s. It’s also worth noting the bank’s inflation policies ensured that periods of roaring growth—the late 1990s, the mid-2000s, the latter 2010s—didn’t get too out of hand.
“We haven’t done this before,” she says. “We’ve kind of gone through the looking glass.”
None of these episodes, however, can hold a light to the economic disruption caused by the pandemic. After two generations of trade globalization, global supply chains—built around low-cost manufacturing in Asia, just-in-time delivery and e-commerce—snapped when confronted by lockdowns that have closed major ports and factories and halted shipping. The billions in stimulus pumped into the economy, in the form of wage supports and subsidies for business, combined with elevated household savings rates, introduced an X factor in spending habits, marked by a dramatic shift from services (such as hair salons, home care) and activities (such as travel) to goods and investments. (Canada’s level of stimulus, measured as a proportion of GDP, is third among advanced economies, according to National Bank Financial.) Finally, the Bank of Canada’s ultra-low interest rates, as well as other monetary stimulus policies such as “quantitative easing” (the central bank’s purchase of corporate and government bonds), yielded billions of dollars in cheap credit that fired up housing prices.
Many institutions are not well-versed in this type of inflation. Yalnizyan, who is also an Atkinson Fellow, notes that to contain inflation monetary policy usually employs tamping down excessive demand. Supply side shocks—defined by the upward pressure on costs such as labour and energy—are a different playing field. “We haven’t done this before,” she says. “We’ve kind of gone through the looking glass.”
The relationship between labour and prices is complex at the moment. The pandemic depressed immigration levels in 2020 and then forced hundreds of thousands of women out of the workforce. “Labour shortages are acute,” says Matthieu Arseneau, deputy chief economist at National Bank Financial, adding that an aging society and disincentives created by pandemic income-support programs have exacerbated the labour market squeezes. “That’s what small and medium enterprises are telling us.” And, he adds: “At this point in the [economic] cycle, it’s surprising to see that kind of labour shortage with unemployment rates so high. The labour market does not seem to have recovered from the crisis.”
While immigration picked up in 2021, some jobs, for example in the restaurant sector, still go begging, says CPA Canada chief economist David-Alexandre Brassard. “I agree with the business community, that [the labour shortage] is weighted a lot on low-wage workers and jobs that require a low level of experience.”
So far, the labour squeeze hasn’t resulted in rising wages, but economists are certainly watching closely for evidence of this development. As a September TD Economics report observed, the relatively strong economic recoveries taking place in B.C. and Quebec could trigger wage-related inflationary pressure. Both provinces, TD notes, “appear to face more upside risks to inflation due to their sturdier economic recovery and tighter labour markets.”
“People are thinking more about inflation than they have in a very long time.”
The impact of energy prices on recent inflation figures is far more apparent and serious. “There’s some parts of the country where energy prices are causing major cost restraints,” says the CFIB’s Gaudreault. In much of Atlantic Canada and Alberta, the energy component of the CPI accounts for a sizable chunk of price increases compared to last year, according to TD Economics. For Canada, overall inflation for August, excluding energy, would have come in at three per cent. But gas and home heating fuel price spikes pushed the high-level figure over four per cent.
Arseneau cautions that strong energy-related inflation this year does, to some extent, reflect pandemic slowdowns from last year, such as a dramatic drop in air travel, commuting and car sales, all of which led to declining demand that has since begun to bounce back. Yet, as he notes, energy price spikes elsewhere in the world offer a bracing reminder about the looming climate change restructuring of global energy markets and the potential impact on inflation.
The investment required to build clean energy generation, as well as the potential implications of fuel shortages, could drive inflation in the coming years. “That’s what we are currently seeing in Europe,” Arseneau says. “We want to keep the public’s support for this transition [to clean energy]. And, if [there was] a shortage of energy because we wanted to move away from fossil fuels too quickly, that could be a problem.”
The other major inflationary shift in the economy doesn’t directly show up in the CPI: housing prices. While mortgage interest, household operating costs, rent and furnishings are included in the so-called basket of goods that make up the CPI, house (and condo) prices are excluded because they are considered to be capital assets. Yet red-hot real estate markets and bidding wars drove home prices to unprecedented levels during the pandemic, due in part to people moving away from denser core areas, shortages of listings and new supply, and exceptionally cheap mortgages. “I think that we’re not done seeing the shelter component of inflation rise,” says CPA Canada’s Brassard. “There’s a risk of shovelling that much money into the housing market. I don’t think it’s going to keep climbing like crazy. But even if it stabilizes, it’s still an issue.”
Debates about whether CPI reflects the actual cost of living, especially in large urban centres, long predate the pandemic and will likely continue after COVID-19 ebbs. But, the implacable nature of the inflation now present in the economy is raising, for some observers, tough questions about what will constitute price stability in coming years.
The Bank of Canada, like other central banks, hasn’t yet offered any hints about whether it plans to revisit the core inflation targets that have driven its decision-making since the early 1990s. The bank’s governor, Tiff Macklem, has warned that rates will go up eventually, but not until circumstances in the economy warrant. “For the policy interest rate, our forward guidance has been clear that we will not raise interest rates until economic slack is absorbed,” he wrote in an op-ed in the Financial Times in mid-November. “We are not there yet, but we are getting closer.”
“It’s a whole new world,” observes Yalnizyan. “People are thinking more about inflation than they have in a very long time.”
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