Corporate Canada's propensity for cash hoarding may be doing more than just holding back Canada's economic recovery. It may be behind Canada's unusually low inflation trend, too.
In a new paper Wednesday from the C.D. Howe Institute that explores Canada's prolonged period with below-trend inflation (it's been two years since the core inflation measure was as high as the Bank of Canada's 2-per-cent target), author Mati Dubrovinsky notes that the historical relationship between inflation and money supply has broken down in the post-recession period. While money supply expanded due to a monetary policy of prolonged low interest rates, this didn't result in a rise in kind of inflation.
He pinpoints the problem to a slowdown in the "velocity of money" – essentially, the frequency with which currency changes hands to buy the current economic output. Increased money supply, it seems, isn't so inflationary if the extra money is not being passed around.
And where is the most glaring pile of extra money that just been sitting there? In corporate coffers. Canadian companies have more than $600-billion on their balance sheets; as a percentage of gross domestic product, corporate cash has almost doubled since 2000.
While policy makers have long complained that companies' failure to reinvest their cash in their businesses has hamstrung Canada's economic recovery and productivity growth, Mr. Dubrovinsky identifies companies' record-high cash holdings as a key factor in the slowdown in money velocity in the past few years – which, by extension, has dampened the inflationary effects of the expansion of the money supply.
"My analysis thus far shows that unpredictable changes in velocity have made monetary policy in Canada less effective," he writes.
Mr. Dubrovinsky recommends that the Bank of Canada should ramp up its monitoring and reporting of inflation expectations, both among Canadian businesses and consumers, in order to better read the tea leaves on money velocity, as these expectations are key determinants of whether the economy will circulate the money supply or sit on it.
This is certainly an issue on the Bank of Canada's radar screen; the central bank, coincidentally, issued its own research paper Tuesday probing inflation's curious trajectory in the world's advanced economies since the recession – initially rising higher than expected in the early stages of recovery in 2009-11, only to sag to surprisingly low levels as the recovery has progressed. That paper also concludes that the inflation surprises may be linked to shifts in expectations that policy makers didn't adequately detect.
Author Christian Friedrich argues that while inflation has historically correlated nicely with a combination of the unemployment rate (a proxy for economic slack) and the forecasts of professional forecasters, a key missing ingredient has been the measure of household inflation expectations. "They mimic the dynamics of inflation expectations by professional forecasters but are significantly more volatile – especially during the post-crisis period," he writes. Coming out of an unprecedented financial crisis and deep recession, and exacerbated by dramatic shifts in energy costs since the 2008-09 crisis that particularly hit home with consumers, the result has been an inflationary moodiness among consumers that hasn't been captured by central bankers' traditional models.
Mr. Friedrich also identifies another key factor in inflation's personality shifts that central bankers have had trouble plugging into their inflation models: The massive swings in government spending policies since the crisis began. The stimulus spending not only created huge fiscal deficits that sparked inflation fears in some quarters, but they injected substantial demand into the economy that fuelled inflation itself; the subsequent shift to austerity and budget balancing has removed demand from the economy and helped snuff inflation's momentum.
So, it would appear that all three key segments of the economy – corporate, household and government – have confounded central banks' inflation policies in pursuit of their own post-crisis agendas and expectations and fears. The question now is whether these were freak effects of an extraordinary economic and financial shock, or whether they have exposed a misunderstanding by policy makers of what makes inflation tick.
David Parkinson