For the first time in three years, headline inflation in Canada has moved above the Bank of Canada’s 2-per-cent target. Whether or not it will continue to increase, the fact that the bank’s three core measures of inflation averaged above 2 per cent for the first time in six years certainly suggests that it will. But the question remains, why has it been so hard to hit the 2-per-cent target? In a recent C.D. Howe Institute paper, we show that demographics – often thought of as an issue for health care or pension costs – has acted as a drag on monetary policy effectiveness and, in turn, has led to lower inflation.
Much work has been done examining the issue of tepid inflation since the financial crisis. Canada has not been immune to this phenomenon, averaging 1.5-per-cent inflation over the past decade. Prominent theories explaining the inability of most countries to reach their targets involve things such as productivity gains and globalization.
On productivity, as the cost of producing a good or service decreases, firms are able to charge end-users lower prices while maintaining similar profit margins. As a result, inflation falls.
On globalization, the emergence in world trade of countries such as China, and in particular their ability to produce goods on the cheap and sell them abroad, has led to lower inflation in much of the developed world.
One culprit for low inflation that has not received much attention is demographics. As societies age, they tend to move away from spending and toward savings. This has two effects: First, it reduces demand for goods and services, which lowers prices; and second, it pushes down the long-term or neutral interest rate that is consistent with output at its potential level and inflation on target. When the neutral rate falls, the Bank of Canada has less room to lower its target overnight rate if it needs to provide stimulus to the economy, as it has had to during and after the financial crisis.
Additionally, aging populations mean more people have moved into the stage of life where they no longer accumulate debt and have either paid it off or are nearing their final payments. This means they are less sensitive to the expansionary monetary policy that has dominated central banking over the past 10 years. In our aforementioned paper, we find that this effect outweighs the fact that aging populations tend to have more fixed-income products that are more sensitive to movements in interest rates. When the bank reduces its target rate, retired households living off interest incomes may be induced to save more rather than spend more, reducing the stimulus provided by the rate cut.
What this all means is that demographics has made it – and will likely continue to make it – harder to hit the bank’s inflation target, and will necessitate more significant changes to the overnight rate target. In times requiring expansionary monetary policy, a lower neutral interest rate will make this more difficult and may result in the bank having to resort more quickly to unconventional monetary policy.
This also begs for fiscal policy to respond to the challenges and constraints central banks now face. In the depths of the financial crisis, we saw the merits of aggressive monetary policy and fiscal stimulus. At the same time, we have seen how inaction or counterproductive fiscal policies can make the job of central bankers more difficult. This is also true when it comes to an aging population. While not always popular, policies in support of higher immigration targets and increasing the retirement age are likely necessary to counteract the effects of an aging population.
We are now a decade out from the Great Recession. As we look ahead and work to understand the coming challenges, we should not overlook the impact demographics will have. And while health-care and pension costs tend to get top billing, we should not underestimate the challenge demographics creates for monetary policy.
Steve Ambler is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, and professor in the economics department at the Université du Québec à Montréal. Jeremy Kronick is a senior policy analyst at the C.D. Howe Institute.