The (not so) great inflation panic of 2021

The hottest debate among economists this year is whether a recent jump in inflation in Canada, the United States and elsewhere is a transitory phenomenon, caused mostly by the COVID-19 pandemic and soon to disappear, or whether – to use the term economists like – it’s “sticky.”

The mainstream consensus is that the recent rise in prices is not about to epoxy itself permanently onto our economy. New evidence in support of that landed Wednesday, when Statistics Canada released its Consumer Price Index for the month of June.

The annualized inflation rate was 3.1 per cent, down from the May rate of 3.6 per cent.

May’s CPI rate represented the largest yearly increase in prices in Canada in a decade, and that has some people wondering whether the Bank of Canada should raise interest rates to cool inflation.

But the numbers have to be understood in the context of last spring’s downturn – which, like most recessions, was marked by a decline in prices. For instance, the price of gasoline has risen dramatically this summer on a year-over-year basis, but only because the price plummeted in early 2020. (Remember when gas was selling for as little as 60 cents a litre in the spring of 2020?) Strip out gasoline, and June’s inflation rate is 2.2 per cent.

Another contributor to inflation in 2021 is the housing bubble. This was partly pumped up by lockdowns that sent some families scrambling to buy homes with backyards, and by low interest rates – both of which are, in different ways, products of the pandemic.

Other pandemic-related price drivers include supplychain bottlenecks that caused shortages of cars, building material and home appliances.

But the Bank of Canada obviously has a limited ability to influence the world price of oil, lumber or cars. Raising interest rates in a vain attempt to lower the cost of these goods could, however, have a significantly negative impact on the Canadian economy and jobs.

In any case, from March of 2020 until this spring, inflation was consistently well below the bank’s government-mandated 2-per-cent target.

And that’s yet another important context for understanding the current inflation, and why letting it play itself out may help the economy recover from the COVID-19 recession.

Or, put another way, the economy will likely be better off if the Bank of Canada isn’t too hasty about tightening monetary policy so as to bring inflation back to its 2-per-cent target.

Under its policy framework set by Ottawa, the bank targets a “2 per cent midpoint of the 1 to 3 per cent inflation-control range.” Some inflation hawks think that means that, if inflation ever goes above 2 per cent, the bank has to slam on the brakes – the most powerful brake being higher interest rates.

Instead, the central bank has wisely said that current inflation is within its 1-per-cent to 3-per-cent range, and there’s still lots of unemployment, so it doesn’t intend to raise its overnight interest rate any time soon.

The bank also expects inflation will fall back to 2 per cent by the second half of 2022, as pandemic-related supply and demand issues fade away.

Plus, there’s a growing body of thinking, much of it based on recent experience, that economies coming out of downturns, during which unemployment rose and price increases were low or negative, are better off averaging inflation out by allowing it to run higher than the target rate for a while.

New research from the Bank of Canada finds that inflation “overshooting” during a recovery, coming on the heels of recessionary undershooting, can promote a faster rebound, and one that is more equitable, by quickly bringing unemployment down for those hardest hit – low-wage workers.

The bank’s inflation-control agreement with Ottawa has been around since 1991. If you read it while wearing blinders, ignoring context and history, it may leave the impression that 2-per-cent inflation is the bank’s singular obsession, and that any move above that level, for whatever reason, must be immediately and robotically attacked.

But the bank always considers other, wider factors. The Bank of Canada Act defines its mission as “to promote the economic and financial welfare of Canada.” To do that, inflation targeting is both a tool and a goal. It’s just that it isn’t the only tool. And it isn’t the primary goal.