Canadians relearning hard economic lessons of ’70s and ’80s
Western economies are reaping the results of a decade of stimulatory monetary and fiscal policy. Quantitative easing—where the central bank injects money into the economy—and low interest rates in the wake of the Great Recession, combined with the deficit surge of the COVID-era, have tilled the soil for the growth of substantial and persistent inflation.
The fear in the wake of the Great Recession, experienced from roughly 2007 to 2009, was deflation but that never quite materialized. Instead, the supply-side disruption and fiscal expansion of the pandemic has taken root generating inflation, which in Canada reached 6.8 per cent in April. This has finally resulted in substantial action from the Bank of Canada via increases in interest rates. In these effects, Canada is not alone because in the end, despite the rumoured end of globalization, world markets remain highly integrated, making the transmission of inflation a global phenomenon.
Of course, the concern now is that we’ve entered a new era of 1970s-style stagflation—that is, slowing economic growth, rising unemployment and inflation. There are some similarities between the 1970s and today. The gradually rising inflation of the late-1960s and early-1970s resulting from a spending boom and looser monetary policy was given a steroid-induced push from the oil price shock brought about by OPEC in 1973. The era’s higher rate of labour force unionization, which in Canada was close to 40 per cent, also increased expectations of inflation-fuelled wage increases. However, persistent and rising inflation requires validation—either fiscal or monetary—and both were provided during the 1970s with looser monetary policy and rising government deficits. It was not until the sharp interest rate increases of the early 1980s that inflation finally started coming down while taming of deficits waited until the 1990s.
Indeed, it’s been argued that the post-COVID monetary and fiscal expansion is a lot like the experience of the 1970s and may require similar measures. The current situation has seen a massive supply shock driven by labour and commodity shortages, first by the global pandemic and now the war in Ukraine. Unlike the 1970s, Canadian unionization rates are much lower at 25 per cent with much of it in the public sector where salary restraint legislation exists in several provinces. But persistent labour shortages are helping drive up costs along with all the other shortages and disruptions. And while interest rates have finally and belatedly started to rise, fiscal stimulus is still very much present in the form of large deficits at both the federal and provincial levels.
Will additional increases in interest rates tame inflation by the end of this summer? Maybe. Or maybe not. Monetary policy generally works with long and variable lags—that is, the time it takes to affect the economy once action is taken and the effects materialize. Fiscal policy has longer decision and implementation lags but once in effect can work much more quickly than monetary policy. As already noted, large deficits are still very much the order of the day and in the short term may work to offset any cooling effects of a monetary policy contraction.
The recent rate increases combined with the anticipated three-quarter percentage point increase by the Bank of Canada in July will take time to have their anticipated effects on the economy. The more likely outcome is a 6-to-12-month period of continued rising interest rates combined with rising prices, rising unemployment as higher interest rates begin to have their effect, and slowing economic growth.
Then, added to all this will be the anticipated fallout from rising interest rates on both the Canadian housing market and the stock market. The potential wealth effects on consumer spending from drops in stock portfolios, pension and investment savings and the value of housing could be large. In the end, we took longer than we should have to deal with inflation and now face the need for a much larger adjustment. Indeed, interest rates may have to rise higher than anyone might have anticipated only a few months ago.
All of this is not new territory for those who lived through the 1970s and 1980s. However, it’s new territory for those labour market cohorts that have known nothing but low interest rates, high rates of borrowing and—pandemic aside—plentiful employment for nearly two decades. It will serve as a relearning of the lessons of yesteryear about the importance of inflation targets, stable monetary growth rules, balanced budgets and low debt levels.