Canada faces perfect inflation storm

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Appeared in the Epoch Times, March 23, 2022
Canada faces perfect inflation storm

With prices soaring at the pumps and the checkout line, Canada’s inflation rate (measured by the Consumer Price Index) hit 5.1 per cent in January, the highest rate since 1991.

While the Bank of Canada raised its policy interest rate from 0.25 per cent to 0.50 per cent on March 2, the central bank may need to do much more to address current inflationary pressures. To some extent, central banks in Canada and other developed countries, after maintaining for months that emerging inflation primarily reflected transitory factors, have seemingly awakened to the unpleasant reality of a longer-run price stability problem. In fact, central banks may now face a perfect inflation storm.

Simply put, inflation happens when the “aggregate demand” for goods and services in an economy exceeds the capacity of the economy to supply that aggregate demand at the current price level. Prices must rise to ration the excess of demand over supply. The gap between aggregate demand and the economy’s capacity to supply goods and services—the economy’s potential output—is potentially influenced by several factors whose importance varies over time.

Aggregate demand is a function of the money supply—typically measured by “M2” where analysts aggregate chequing accounts, savings and time deposits, and money market funds—and the velocity of the money supply, measured by the rate of turnover of the money supply. So, if the money supply in a given period equals $100 and there’s $200 of spending, the velocity of money equals two. Aggregate demand will therefore increase with increases in the money supply and/or increases in the velocity of money.

Potential output is a function of the number of workers and the average productivity of the workforce. An increase in the supply of labour and/or the average productivity of labour results in greater potential output of an economy. If potential output increases less than aggregate demand, the outcome is inflation.

Until recently, central banks blamed temporary decreases in labour productivity—and, therefore, inflation pressures—on COVID-related disruptions to global supply chains. In fact, labour productivity growth in Canada, the United States and the European Union averaged less than 1 per cent per year over the 2012-2019 period, and with the exception of the U.S., labour productivity growth was slower in the second half of the period than the first. This represents a dismal labour productivity performance by historical standards.

Going forward, there’s no obvious reason to expect a substantial increase in labour productivity growth. Indeed, the move to substantially reduce the use of carbon fuels and the seeming end to global trade and investment liberalization may help produce even slower productivity growth. Nor should one expect a faster increase in the supply of labour to compensate for slower productivity growth. Aging populations in developed economies over the next two decades suggest a stagnant, if not declining, workforce.

On the demand side, a sharp increase in Canada’s money supply undoubtedly has contributed to the recent surge in inflation. Specifically, M2 increased by 28 per cent from December 2019 to December 2021 compared to 13.4 per cent from December 2017 to December 2019. Clearly, unless the growth rate of the money supply slows substantially, or the turnover of the money supply declines sharply, aggregate demand will continue to increase substantially. As inflationary pressures build, velocity is more likely to increase than decrease as households and businesses accelerate their purchasing in advance of anticipated higher prices.

In short, the various determinants of inflation point to serious continued danger ahead. Central bankers, including officials at the Bank of Canada, will have to navigate through an inflation storm like we haven’t seen in at least 40 years.