Stephen Poloz is special adviser at Osler, Hoskin and Harcourt and author of The Next Age of Uncertainty. He is a former Bank of Canada governor and sits on the boards of Enbridge Inc. and CGI Inc.
The implosion of a couple of U.S. banks and Credit Suisse serves as a reminder that there are many things we just don’t know right now.
We think we know how banks, companies and families will react to rising interest rates, but economic models are built on historical experience, and often fail when events go outside the norm. There is always a deterioration in bank balance sheets as interest rates rise; the consequent tightening of credit is part-and-parcel of the slowdown-inducing actions of central banks. However, not only has the path of interest rates been highly unusual this time, but our economic model histories do not include pandemic shutdowns, massive fiscal injections, quantitative tightening, seismic geopolitical shifts or war, either.
Consider Canada’s fourth-quarter GDP report: flat growth overall, weaker-than-expected business and housing investment down three quarters in a row; consumption spending was up, but got an assist from government tweaks to the GST rebate and Old Age Security. This all suggests that higher interest rates are working more rapidly than predicted by our models, perhaps because of elevated household debt levels. And yet, at the same time, unemployment remains at historic lows, with thousands of new jobs still being created, which doesn’t seem to fit. These inconsistencies make the outlook for inflation uncertain, but it has been declining faster than economists have forecast.
It is well known that inflation depends on both demand and supply, as markets find the price where the two are equal. If demand suddenly rises, prices rise, and we have conventional inflation pressures. But if supply suddenly falls, prices rise then, too. The real confusion for economic forecasters comes when supply suddenly improves – then we can get solid economic growth and job creation and falling inflation, all at the same time. Fortunately, that has been happening, and it can continue to happen.
Most of the time, supply is just a steady process fed by work force growth, business investment and productivity. But that has simply not been the case for the past three years, which have been dominated by supply shocks. The COVID shutdown in the spring of 2020 cut economic supply by nearly 20 per cent in Canada. By fall, the economy was back to 97 per cent to 98 per cent of normal. But sporadic shutdowns in markets such as China and Taiwan created critical supply shortages and logistical logjams throughout 2021 and into 2022. Then Russia’s invasion of Ukraine disrupted global supplies of food, fuel and fertilizer, both directly and through a series of subsequent sanctions. Moreover, we have had floods, polar vortexes, avian flu and now citrus greening disease, all supply shocks far outside normal experience.
Those supply shocks lie behind most – but certainly not all – of the surge in inflation experienced around the world in the past year. Demand pressures have played a role, too – the unexpectedly fast recovery of the economy from the pandemic and the delayed renormalization of interest rates created the conditions for a modest overshoot of inflation quite apart from supply shocks. But now most countries are seeing inflation decline as those supply restrictions dissipate. Some prices have actually dropped, such as those for energy and fertilizer; food prices will take longer to ease, because fuel and fertilizer are inputs to food production and it takes months for lower input prices to show up at the grocery store.
Canada’s inflation rate of 5.2 per cent in February – once again, lower than expected – consisted of a rise of 4 per cent during the February-August period last year (the effects of the invasion of Ukraine) and a rise of 1.2 per cent since then. What this means is that Canada’s inflation rate will continue to decline during the coming six months, unless there is some new supply shock to disrupt the arithmetic. Developments on the demand side are working in the same direction: Percolating unease around the health of the global financial system and the associated weakness in stocks is tightening financial conditions even further, while denting consumer and business confidence besides.
One place where supply remains tight is our labour market, and this is the main source of confusion today. Because of our aging population, our only source of net growth in the supply of workers is immigration, which slowed significantly during the pandemic. But our labour force has grown by 454,000 over the past year. This is largely owing to a pickup in immigration, but also to increased participation in the work force by parents with improved access to child care, and by an influx of seniors. When a new worker joins the work force, they generally add more to supply than to demand. In other words, growth in jobs, incomes and GDP are not always a harbinger of higher inflation; in fact, they are at least as likely to be disinflationary.
This unusual mix of supply and demand shocks is understandably confusing to economic forecasters. Happily, promoting supply led growth is an easy way to hedge against the risk of being wrong, while greatly increasing the odds of a soft landing as inflation declines. More accessible child care is already having this effect, as will the completion of the Trans Mountain pipeline and streamlining immigration processes. Other supply enhancing policies would include making permitting faster, investing in more rail and port capacity, and harmonizing interprovincial regulations.