A basket of groceries a trolly at a supermarket in London, on June 10.Alastair Grant/The Associated Press
Kevin Yin is a Tobin Pre-Doctoral Fellow in Yale University’s economics department and will be starting his doctorate at the University of California, Berkeley.
Canadians are bearing the cost of a record-high period of inflation and politicians are pointing fingers at fiscal and monetary responses to the pandemic. But inflation wasn’t created by these domestic policies, and neither can it be entirely solved by them.
Justin Trudeau’s government was sending billions in stimulus checks and the Bank of Canada was purchasing bonds en masse from financial institutions, actions that led critics of those policies to label our inflation a “made-in-Canada” phenomena. But there are some obvious confounders to that criticism.
COVID-19 was also grinding supply chains to a halt, driving up the costs of critical intermediate goods and services. Shortly afterward, Russia invaded Ukraine, forcing the West to put sanctions on Russian imports. Oil and gas, which are key inputs to all kinds of production, skyrocketed in price. With difficulty getting supplies, finding transportation, and paying for production, firms rapidly raised their prices.
There are plenty of reasons to put the emphasis on these latter circumstances as the true culprits for inflation.
If the government’s fiscal policy were at fault, we would expect to see some evidence of an explosion in aggregate demand – the total demand for domestic goods – beyond prepandemic levels. Handing people cheques, all else equal, can serve as “helicopter money” where everyone feels richer and spends more. However, in this case the money came after many businesses shut down and millions lost their jobs. As a result, consumer spending barely returned to trend levels after the stimulus. The policy was only enough to keep people on their feet while the pandemic cooled, and at best that’s what it did.
Nor can we put the blame much on the central bank’s quantitative easing (bond purchasing) policy. Prominent critics of the bank believe that the supply of money is ultimately the only cause of inflation, a naive version of Milton Friedman-style monetarism.
While intuitive, it obscures two critical and related points. First, the effects of raising the money supply take time to trickle into the price level and must go through certain channels that determine its effect on prices. When the central bank buys bonds, the money it pays gets injected into the economy through the private banks it purchases from.
Amid the pandemic, Canadian private banks did not plow this newfound cash into investments or businesses but rather held onto it as a buffer for uncertainty. Without the majority of that money reaching everyday consumers or businesses, it could not have significantly raised the price of say, eggs and cheese.
The second issue is that the public’s expectations about the central bank’s desire to control the money supply in the long run matters more than the actual supply of money. Realistically, the majority of Canadian businesses and the general population are not looking at technical indicators such as the M2 money supply.
They pay far more attention to the central bank’s messaging on the inflation target and interest rate response. Thus if the money supply runs high, unless people suddenly start observing the supply and believe that the central bank has given up on reigning it in, inflation will not reflect it.
For these reasons, quantitative easing during the 2008 financial crisis did not result in inflation. Nor did Japan’s famous bond-purchasing policy that ran for half a decade at the turn of the millennium. On the other hand, Germany, which did not experience a large spurt of monetary growth during the pandemic, still experienced inflation peaking at more than 10 per cent.
All of this absolves both the Liberal government and the Bank of Canada to some extent. However, it is not much comfort for Canadians. If domestic policies were not the primary cause of inflation and the true sources are issues in supply chains and oil prices abroad, monetary and fiscal levers can do little to fix the issue.
While the recent rate hikes may help prevent a wage-price spiral by reigning in wage growth, they cannot help firms find alternative suppliers or cover increased production costs.
Similarly, prudent government spending helps us avoid fiscally induced inflation, but it cannot stop it from other sources.
Trudeau could shore up trade agreements and put in pandemic protocols with friendly nations to make our supply chains more robust in the future. He could negotiate with oil-producing countries on import deals and, in the longer term, perhaps diversify to alternative energy sources. But the Canadian government cannot end the current inflation on its own. Canadians may face rising prices for some time to come.