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“I don’t think we are going to go back to that environment of low inflation,” said Christine Lagarde, president of the European Central Bank, during a panel discussion at an event last week.POOL/AFP/Getty Images

In the decade before the pandemic, the chief concern of the world’s leading central bankers was inflation being too low. Today, they are scrambling to get a handle on soaring consumer prices and cautioning that the era of benign inflation is a thing of the past.

“I don’t think we are going to go back to that environment of low inflation,” said Christine Lagarde, president of the European Central Bank, during a panel discussion at an event last week in Sintra, Portugal.

The worldwide spike in consumer prices over the past year has reawakened memories of the 1970s and early 1980s – when commodity price shocks and economic policy mistakes led to years of high inflation.

It has also spurred debate about the longer-term trajectory of inflation. For the better part of four decades, monetary policy in most advanced economies had been defined by disinflationary forces, such as the globalization of labour markets and the proliferation of cheap goods from China. The events of the past two years have rattled those foundations.

“There are forces that have been unleashed as a result of the pandemic, as a result of this massive geopolitical shock that we’re facing now, that are going to change the picture and the landscape within which we operate,” Ms. Lagarde said.

The Bank of Canada and most Bay Street analysts expect the annual rate of inflation in Canada – which hit a four-decade high of 7.7 per cent in May – to crest in the coming months and decline through the second half of the year.

But it’s a long road back to the central bank’s 2-per-cent inflation target. Even the bank doesn’t expect to get there until 2024, and that path is dependent on wild cards such as global oil prices and consumer psychology.

Looking further ahead, the questions get more theoretical. Will a process of deglobalization increase manufacturing costs and push up the prices of goods? How will the transition to a low-carbon economy, or the retirement of the baby-boomer generation, affect energy prices and labour markets?

There is plenty of disagreement on each of these issues. But there’s a sense, at least among influential central bankers, that we’re at a turning point. Advanced-economy inflation is no longer a relic of the past. Going forward, policy-makers will face difficult trade-offs to keep prices stable.

“The global economy is undergoing a series of major transitions,” former Bank of Canada and Bank of England governor Mark Carney said in a March speech that focused on the economic implications of climate change. “The long era of low inflation, suppressed volatility and easy financial conditions is ending. It is being replaced by more challenging macro dynamics in which supply shocks are as important as demand shocks, increasing inflation, volatility [and] interest rates.”

The most pressing task is slowing the upward march of consumer prices – something many central banks, including the Bank of Canada, have pledged to do, even if it means causing a recession by chocking off demand with higher borrowing costs.

There are positive signs on this front. Oil and other commodity prices have fallen in recent weeks, and shipping rates on major trade routes have declined from record highs. Higher interest rates, meanwhile, are already weighing on demand in key segments of the Canadian economy, notably the housing market. Taken together, this suggests the rate of inflation should start trending down in the back half of the year.

There is, however, a major risk. The longer inflation remains high, the more likely it is to get baked into people’s psychology. If businesses and consumers expect prices to keep rising and the value of the dollar to keep falling, they will set higher prices and demand higher wages in a self-reinforcing cycle.

This dynamic, known as a wage-price spiral, took root in the 1970s and proved hard to dislodge. It took punishingly high interest rates and a deep recession in the early 1980s – known as the Volcker Shock, after then-U.S. Federal Reserve chair Paul Volcker – to finally break the inflationary mindset.

Concern about inflation expectations is a key reason the Bank of Canada and other central banks have raised interest rates so aggressively in recent months. The Fed announced a 0.75 percentage point interest rate hike last month, which is three times the size of a normal increase and the largest since 1994. The Bank of Canada is widely expected to follow suit at its rate decision on July 13. It has already raised its benchmark rate at three consecutive meetings.

“I think the stern messaging from central banks, and as well these non-standard huge rate hikes, will help to contain inflation expectations,” said Katherine Judge, an economist with Canadian Imperial Bank of Commerce, in an interview. “But at the same time, inflation expectations are the No. 1 risk to our forecast. So if those rise, obviously we’ll need to see more rate hikes to cool the economy and inflation.”

The evidence for inflation becoming entrenched is mixed. A pair of surveys published by the Bank of Canada this week showed a worrying rise in both consumer and business inflation expectations. Wage growth – half of any wage-price spiral – is accelerating but remains muted compared with what is happening in the United States.

Rafael Gomez, professor of employment relations at the University of Toronto, says a 1970s-style wage-price spiral is unlikely given the decline in labour’s bargaining power in recent decades. Central banks also have more credibility today, which could anchor expectations.

“The fundamental structure of our economy is so different,” Prof. Gomez said. Private-sector unionization is far lower today than in the 1970s. Likewise, fewer employment contracts contain cost-of-living-adjustment clauses, which automatically keep pace with inflation.

While much of the conversation is focused on near-term inflation pressures, the first consumer price shock in a generation has pushed economists to look at longer-term structural changes to the economy that could affect inflation over time.

Discussions tend to revolve around three themes: deglobalization, aging populations and the transition to a low-carbon economy.

When explaining the period of low and stable inflation that began in the mid-1980s, economists often point to globalization. The development of worldwide supply chains lowered manufacturing costs and brought hundreds of millions of workers into the international labour pool, putting downward pressure on wages.

This paradigm has come under strain. The pandemic disrupted global manufacturing and transportation networks, leading to product shortages and higher shipping costs. More recently, sanctions against Russia have reversed decades of economic integration that followed the end of the Cold War.

These developments could spur a transformation of global business. Some companies are building up inventories and focusing on supply chain resilience over pure efficiency. Politicians, meanwhile, are emphasizing the importance of trading with allies rather than adversaries – a shift they have dubbed “friend-shoring.”

Theoretically, this could increase manufacturing costs and push up prices. So far, however, the evidence is relatively sanguine, Ms. Judge said.

“We’re not seeing a mass reshoring of production,” she said. “We’ve seen more a re-globalization, where there’s still a reliance on trade, but it’s just with different countries.”

A closely related concern has to do with changing demographics. An influential argument, popularized by British economists Charles Goodhart and Manoj Pradhan in their 2020 book The Great Demographic Reversal, suggests that the key driver of low inflation in recent decades was China’s entry into the global economy.

As China’s population ages, there’s no comparable pool of new workers waiting on the sidelines to enter the labour market, they argue. Moreover, the mass retirement of baby boomers around the world could leave a scarcity of workers relative to retirees, bidding up wages and feeding through to inflation.

The book has received renewed attention in recent months, but it’s not without critics, who tend to point to Japan as a counter-argument. Japan has struggled with persistently low inflation, even deflation, for decades despite having the world’s oldest population.

Finally there’s so-called “greenflation,” caused by climate change and the transition to a low-carbon economy. Demand for certain goods (battery metals, electric vehicles) is likely to outstrip supply for some time. Moreover, energy prices could rise, at least in the medium term, as a result of carbon taxes and a shift to more renewable sources.

Mr. Carney highlighted this dynamic in his March speech: “While fundamentally positive and likely to be less inflationary than keeping with current insufficient climate policies, the net-zero transition can be expected to put upward pressure on inflation during the initial decade of the transition, until the lower levelized costs of clean energy weigh on prices thereafter.”

Whether any of these structural changes – deglobalization, aging populations, renewable energy – result in permanently higher inflation remains to be seen. Beata Caranci, chief economist at Toronto-Dominion Bank, pointed to a key distinction between inflation, which is the rate at which prices increase over time, and the actual level of prices.

“I would totally agree that we end up with structurally higher levels of prices,” Ms. Caranci said in an interview. “But the rate of [price] acceleration to me is not sustainable because it just is too crippling on the demand side [of the economy].”

She offered an example: For the current annual inflation rate of almost 8 per cent to persist for another year, the price of a barrel of oil would need to rise to US$175 and remain there. But oil prices at that level would almost certainly trigger a recession, dampening demand throughout the economy and weighing on the speed of inflation.

She expects the rate of inflation in Canada to come down over the next two years, although she is not predicting a return to 2 per cent any time soon. The Bank of Canada has an inflation target range of 1 per cent to 3 per cent, she noted.

“What’s a good enough standard? That’s what we’re after,” she said. “I think if they’re near the top end of their mandate, I would consider that a success.”

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