Focus
July 05, 2024 | 13:33
Ten Inflation Fables
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Ten Inflation FablesWhat caused the sustained burst of inflation from 2021 to 2023, what prompted it to (mostly) recede, will it stay down, and what have we learned about dealing with inflation in the future? It seems that everyone has an opinion on these questions—some are well-considered, some are half-truths, and some are just off the rails. These are no small debates, and getting them right will help inform policy in the years to come, especially if we ever encounter anything remotely akin to the past four years. |
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Our view is that a rare set of circumstances on both the supply and demand sides coalesced to set inflation alight. Supply was constrained by staggered and uneven pandemic shutdowns, workers unwilling or unable to return to work, and some specific (but severe) material shortages. Meantime, demand was being juiced globally by highly stimulative fiscal and monetary policies, to avoid an even deeper recession. Thus, demand was fired up to extraordinarily high levels at the very time that supply was well below normal—a classic recipe for rising inflation. And then a commodity shock intruded at a crucial moment. The fix required repairs on both sides of the supply and demand ledger, and any analysis that ignores that reality is incomplete, and possibly misleading. Below we consider 10 misconceptions, myths, or just plain wrong views that have been put forth on inflation this cycle. 1) Inflation is transitory. We’ll warm up with an easy one, and the original sin in this unfortunate episode. It’s true that inflation has ebbed from its 2022 peak of 8% to below 3% in much of the advanced world this year (Chart 1). But it took the most ferocious monetary policy tightening in 40 years to quell prices, and even now inflation is still a percentage point above pre-pandemic trends. Moreover, inflation has averaged 4% in the developed world since the start of 2020, more than double the prior four years. We’ll never know for sure where inflation would have been if largely left to its own devices as the supply chain healed, but we do know that services inflation is still running hot at 4.4%, even as goods prices are back to normal. |
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2) Inflation hit a record high. One more softball before getting to the trickier subjects. It’s true that two generations of North Americans have just had their first taste of real inflation. But no advanced economy saw record price increases. Looking beyond spikes immediately after WWII, the post-war U.S. high was 14.6% in March 1980, and Canada reported 12.9% headline inflation in July 1981 (Chart 2). Not to be out-done, Britain poked above 20% headline inflation in 1975, while Italy ventured into that terrain a number of times in the 1970s/80s. Even Japan, which only topped out at 4.4% inflation this cycle, rose above 20% in the mid-1970s. The one economy that was an outlier was Germany; its 8.9% peak on the national CPI in 2022 was the highest in more than 70 years—not a record, but the highest for most adult lifetimes. 3) Inflation was primarily caused by Russia’s invasion of Ukraine. The spike in energy, grain and metals prices in early 2022 clearly made a fraught situation worse, but we had a serious inflation issue on our hands even before February 2022. Advanced world inflation stood at 6% at that time, and 3- and 6-month trends were above 7%, not far from where the yearly trend would top out later that year (at nearly 8%). Most major measures of commodity prices were back to pre-invasion levels by the end of 2022, and yet high inflation lingered for much longer (Chart 3). Indeed, the BoC’s commodity price index is now no higher than it was in 2014, a decade ago. |
4) Higher interest rates couldn’t bring down this supply-driven inflation. We heard this one a lot in the early days of the rate-hike cycle. Essentially, the argument boiled down to: The inflation run-up was caused by supply chain issues, as well as energy and food prices, and monetary policy couldn’t do anything about opening up factories, or pumping more oil, or growing more wheat. This was a classic case of just looking at one side of the ledger, and ignoring the fact that spending had been turbocharged by extraordinarily loose fiscal and monetary policies in 2020/21. Arguably, the supply side issues were exaggerated, and the real issue was that soaring demand simply overwhelmed existing production capacity in many sectors (a view we still favour). So, Step 1 in the inflation fight was to take the steam out of demand. It’s notable that inflation topped out within months of the first rate hikes in 2022. We’ll never know for certain whether that was due to cooler demand or repaired supply, but it’s reasonable to say that we needed both blades of the inflation scissors to back away. |
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5) The carbon tax was a big driver of Canadian inflation. While this one seems contentious, it’s actually relatively straightforward. First, there is no debate that the structure of Canada’s carbon tax does add to inflation—the price increases at the pump and for natural gas do indeed lift the CPI, while the essentially offsetting rebates boost disposable income but have no direct effect on CPI. StatCan helpfully provides a specific measure of inflation before and after increases in indirect taxes (which would include the carbon tax)—over the past four years, overall inflation has averaged 4.37%, and it’s been 4.27% excluding these taxes. (There are other sales tax changes included here, but they are mostly offsetting, with some hikes and some cuts; e.g., Ontario’s gasoline tax.) So, the carbon tax has added roughly 0.1 ppt to inflation per year since 2019. That is up slightly from the four prior years, when such taxes added 0.07 ppts per year, but hardly a major driver. On the flip side, this is only the direct impact, and higher energy costs can filter into many other prices, but we are almost certainly talking about second-decimal place impacts. |
6) Corporate greed was the driving factor in the inflation run-up. Now we are truly wading into contentious waters. It is the case that non-financial, non-resource sector profit margins widened somewhat in 2021/22, initially adding pressure to the upswing in inflation. However, was this cause or effect? It’s hardly a new development that companies would aim to maximize profits—that’s pretty much a given at any time. What was new was the backdrop that allowed prices to rise; a massive mismatch between constrained supply and fiery demand. Moreover, the scale of the rise in margins simply does not account for more than a fraction of the upswing in prices. For example, U.S. after-tax earnings/GDP rose from 10% in 2019 to a peak of just over 11% in 2021Q2, accounting for some of the initial inflation burst, but then promptly retreated to pre-pandemic levels (Chart 4). And, yet, we still have sticky underlying inflation, pounding home the point that something much greater is at work. 7) Frequent prices changes were a cause of inflation. This is a line of reasoning that some policymakers have latched onto, including the Bank of Canada. But, similar to the prior point, the change in corporate pricing behaviour is arguably an effect of rising inflation not a cause, and it’s nearly a tautology that doesn’t really explain the “why?”. In other words, we don’t doubt that companies were changing prices more frequently in the past few years (Chart 5), but that doesn’t begin to explain the root cause of why this was the case, and what conditions prompted this change. Producer prices rose 14% in 2021 and then another 13% in 2022, the largest two-year rise in 50 years. Is it any wonder that consumer prices were also then adjusting rapidly as well? We think not. 8) Food price inflation was uniquely problematic in Canada. While food inflation was undoubtedly a serious issue, and a big reason why inflation expectations were at risk of becoming unanchored, it simply was not specific to Canada. The attached chart shows that food inflation was a global issue; if anything, Canada’s grocery price inflation was less intense than elsewhere in the advanced world. For example, Canada has seen food from stores rise 26.4% versus the 2019 average (or roughly 4.8% a.r.), the same as for U.S. food prices, but less than in Britain or Europe (Chart 6). And that’s despite a 3% drop in the Canadian dollar over that period, which pressured imported food costs. Yes, food has been a big issue, but it’s not a Canada-specific issue. |
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9) Price controls could have been a useful tool containing inflation. This view has emerged in some circles recently, and we could fill a book with the response. Suffice it to say that full-on wage & price controls were attempted in the 1970s in both the U.S. and Canada (and note the “wages” part) with no true success. In Canada’s case, inflation did ebb somewhat during the controls (arguably due to global factors), but then came roaring back with even more force after they were relaxed. Not unlike rent controls, price controls are easy to put in place, but are devilishly hard to remove, once everyone appreciates how supply is being further squeezed. More fundamentally, the price mechanism sends a very important signal to both buyers and sellers when there is a crunch—rising prices tell buyers to back off, while encouraging new supply to emerge. Interfering with that crucial market signal threatens to prolong or even deepen supply/demand imbalances. They may be considered in true emergency situations for some necessities, but as a general tool for macroeconomic policy, price controls are simply a bad idea. |
10) Wages have been unable to keep up with inflation. We addressed this misperception in last week’s Feature, and it’s a widespread view that wages have fallen far behind inflation. But the reality is that in both the U.S. and Canada, most measures of wages have, in fact, managed to rise faster than inflation over the past five years, and are basically in line with longer-term trends in real wages (Chart 7). One of the issues is that real wages actually surged early in the pandemic (adjusting for distortions caused by the lockdowns), but have since receded back to their underlying trend as inflation flared. It’s likely that the readjustment to trend makes it seem so painful for real earnings. This list is by no means meant to be all-encompassing. We could have also mentioned: i) higher interest rates cause inflation; ii) rising home prices and rents are all a supply issue, and iii) fiscal policy was not a factor in the inflation surge. The point is that there has been a great inflation of inflation delusion in recent years. |
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