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Peter Hall: Why inflation is not really the problem

Bank Of Canada Governor Tiff Macklem Holds News Conference
Bank Of Canada Governor Tiff Macklem Holds News Conference

Most readers are already offended, having read 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 just two elements, and inflation is one of them. Moreover, inflation is arguably worst in the beginning, when prices are outpacing incomes, putting the bite on real purchasing power — the second-quarter gap between CPI inflation and the rate of hourly wage increases hit four per cent, meaning for now, households are poorer.

For businesses, the bite is more like a chomp, given the average increase in input costs of about 10 per cent and recent bottom-line results. Worse still, this was a beast that was considered long dead, and is now resurrected and wreaking havoc. If this isn’t really the problem, then what is?


First and foremost, central banks will win the fight. Although it has been decades since they last conquered the beast, their playbook is well-rehearsed, proving itself through various business cycles over the past few decades. Central bankers have the tools to continue tightening, not just until inflation itself is subdued, but more significantly, until inflationary expectations are completely quelled. If so, today’s inflation is temporary, and the only real debate is, how temporary.

But that’s the key to the problem. Inflation might soon be mastered, but at what cost? Economies everywhere will react negatively, and indeed are already showing signs of recession or at the very least, slowdown. 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 to date, there’s a lot more weakness in store. It won’t hit every economy the same. Thankfully, the bulk of the world’s “driver” economies have ample evidence of pent-up spending pressure. Rate hikes in those fortunate zones are actually accommodating growth.

Canada has some pent-up spending in reserve, but our runway is a lot shorter. Here, housing markets have been red-lining for years, debt-to-income levels are sky-high, and the average household’s wealth is heavily dependent on the value of the principal dwelling. Add to that the instant debt-sensitivity of the larger variable-rate mortgage cohort, the shock for those who opt to lock in at a higher rate, and the ultimate impact of rate resets when current mortgage contracts expire. Given this backdrop, at least 60 per cent to 70 per cent of our gross domestic product is highly sensitive to rate hikes.

It gets more somber. Soft landings are as tricky to achieve as they are desirable. Put more directly, monetary authorities have been known to overdo it. We can hardly blame them; monetary policy is a blunt tool at best, and perfect outcomes usually require a lot of luck. Moreover, cracking the psychology of inflation almost dictates monetary overreach, especially after a lengthy phase of well-behaved prices.

Math is also a problem. The most-quoted, up-to-the-minute inflation numbers are in actual fact quite dated, and the inflation fix can actually be in long before consumers or businesses realize it. That’s because we use this month’s prices compared with those of a whole year earlier. We tend to do it this way for good reasons: the numbers are easy to grasp, and useful for compensation adjustments and a whole array of other pricing decisions. The trouble is that monthly price behaviour can be well in line with targets — or even under target — long before it shows up in the headline numbers. In fact, it can take a full 12 months until that becomes clear — and at that point, it is almost always too late for the economy.

Take 1991. Amid monetary tightening, the new year brought the GST, which added seven per cent to the cost of most goods and services. Not surprisingly, the consumer price index jumped instantly, to 6.9 per cent. Fearing a re-kindling of higher price expectations, the central bank went to work. By the end of the year, year-over-year increases in the consumer price index were down to 3.8 per cent, and core price growth was just 2.9 per cent.

Success, right? Wrong. When 1992 arrived, the GST was fully embedded — that is, the year-to-year change disappeared. In monthly terms, prices were deflating. In January 1991, yearly price growth fell to 1.8 per cent, and by mid-year, all-items inflation was just 1.1 per cent. Suddenly, worry shifted to possible disinflation, or worse, deflation.

While a new national sales tax isn’t a worry this time, the dynamic is still the same. It doesn’t get much airplay, but on a monthly basis, core price growth has been slowing quickly, from the double-digit level in May to about four per cent in October. This is a remarkable shift, given that we are only in our ninth month of tightening. Allow time for the full effects to take hold, and we could be back to 1992.

Ah, but we got through it then. Won’t this time be the same? Not necessarily. Disinflation and deflation are much trickier beasts; the central bank playbook on those is far less clear than for inflation. Just ask Japan, where disinflation and deflation are decades-long mysteries. Human behaviour causes deflation to persist — if prices are going to be lower tomorrow, why buy today? Or for that matter, why buy at all, unless you simply have to? In this way, deflation begets deflation.

Can we escape the deflationary trap? That largely depends on the state of fundamental demand. If the economy is indeed overstretched, consumers can delay purchases for a lot longer than usual, abetting the malaise. Businesses that depend on domestic demand will feel the pinch. If there’s a glimmer of hope, it’s likely in exports. Stronger fundamentals in the United States and elsewhere suggest that external markets will be more resilient.

Ultimately, inflation’s not the main problem. It’s the reaction to the remedy that will tell the tale. That reaction won’t be the same in all countries — but Canada’s weak fundamentals suggest a more acute response here.

Peter Hall is chief executive of Econosphere Inc. and a former chief economist at Export Development Canada.