Most readers are already offended after reading the title. Let me explain.
Clearly, inflation is a huge problem for households, businesses, government budgets – and, of course, for monetary policymakers. Arthur Okun’s famous misery index has only two elements, and inflation is one of them. In addition, inflation is arguably worst at the beginning, when prices rise faster than incomes, straining real purchasing power. poorer.
For companies, the bite is more of a chomp, given the average increase in input costs of about 10 percent and recent bottom-line results. Even worse, this was a beast that was thought to be long dead, and has now been resurrected and wreaking havoc. If this isn’t really the problem, what is?
First and foremost, the central banks will win the battle. While it’s been decades since they last conquered the beast, their playbook is well rehearsed and proven in several business cycles over the decades. Central bankers have the tools to continue tightening, not only until inflation itself is subdued, but more importantly, until inflationary expectations are completely subdued. If so, today’s inflation is temporary, and the only real discussion is how temporary.
But that’s the key to the problem. Inflation could soon be mastered, but at what cost? Economies everywhere will react negatively, and indeed they are already showing signs of recession or at least slowing down. That’s a scary prospect, given that it can take up to 18 months for an interest rate change to impact the real economy; given the timing of increases so far, much more weakness is in store. It will not affect every economy to the same extent. Fortunately, most of the world’s “driving” economies have ample evidence of pent-up spending pressures. Interest rate hikes in those lucky zones actually drive growth.
Canada has some pent up spending in reserve, but our runway is a lot shorter. Here, the housing markets have been red lines for years, debt-to-income ratios are sky-high and the wealth of the average household is highly dependent on the value of the main home. Add to that the immediate debt sensitivity of the larger variable-rate mortgage cohort, the shock to those who choose to lock in higher interest rates, and the eventual impact of interest rate revisions when current mortgage contracts expire. Against this background, at least 60 to 70 percent of our gross domestic product is highly sensitive to interest rate hikes.
It’s getting darker. Soft landings are as tricky to achieve as they are desirable. More directly, monetary authorities have been known to exaggerate. We can hardly blame them; monetary policy is a blunt tool at best, and perfect results usually require a lot of luck. In addition, the crunch of inflation psychology almost dictates monetary overshoot, especially after a long phase of well-behaved prices.
Mathematics is also a problem. In fact, the most widely quoted, up-to-the-minute inflation numbers are quite dated, and the inflation fix may actually take place long before consumers or businesses realize it. That’s because we’re comparing this month’s prices to those of a full year earlier. We tend to do it this way for good reasons: the numbers are easy to understand and useful for compensation adjustments and a slew of other pricing decisions. The problem is that monthly price behavior can be well in line with the targets – or even below the target – long before it appears in the headlines. In fact, it can take up to 12 months for that to become apparent – by which time it’s almost always too late for the economy.
Take 1991. Amid monetary tightening, the new year brought with it GST, which added seven percent to the cost of most goods and services. It is therefore not surprising that the consumer price index suddenly shot up to 6.9 percent. Fearing that higher price expectations could reignite, the central bank went to work. By the end of the year, year-on-year increases in the consumer price index had fallen to 3.8 percent and core price growth was just 2.9 percent.
Success, right? Wrong. When 1992 arrived, the GST was fully embedded — that is, the year-to-year change disappeared. Monthly prices fell. In January 1991 annual price growth fell to 1.8 percent and inflation for all items was only 1.1 percent by mid-year. Suddenly the concern shifted to possible disinflation, or worse, deflation.
While a new national sales tax isn’t an issue this time around, the dynamics are still the same. It doesn’t get much airplay, but on a monthly basis, its core price growth has slowed rapidly, from double-digit in May to about four percent in October. This is a remarkable shift as we are only in our ninth month of tightening. Give it time for the full effects to kick in, and we could be back to 1992.
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Ah, but then we got through it. Won’t this time be the same? Not necessary. Disinflation and deflation are much trickier beasts; the central bank’s playbook on this is much less clear than for inflation. Just ask Japan, where disinflation and deflation have been mysteries for decades. Human behavior causes deflation to persist – if prices will be lower tomorrow, why buy today? Or why buy at all, unless you just have to? In this way, deflation leads to deflation.
Can we escape the deflationary trap? That largely depends on the state of the fundamental demand. If the economy does become overloaded, consumers may delay purchases for much longer than usual, fueling the slump. Companies dependent on domestic demand will feel the squeeze. If there’s a glimmer of hope, it’s probably in exports. Stronger fundamentals in the United States and elsewhere suggest that external markets will be more resilient.
In the end, inflation is not the biggest problem. It is the response to the remedy that will tell the story. That response won’t be the same across countries, but Canada’s weak fundamentals suggest a more acute response here.
Peter Hall is CEO of Econosphere Inc. and former chief economist at Export Development Canada.