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While not as crowded with shoppers as it might normally be, the Eaton Centre was open for business with people lining up outside a few stores in Toronto on March 10, 2021.Fred Lum/The Globe and Mail

At first blush, it seems absurd. How can we be worrying about inflation now, of all times?

We have not yet emerged from a pandemic that sent Canada, and the world, into the deepest recession in nearly a century. Even as major industrialized countries have recovered substantially from the depths of the downturn, G7 inflation is just 1 per cent – barely half of where it stood before the pandemic. Canada’s own inflation rate last month was also 1 per cent, just half of the central bank’s long-standing 2-per-cent target, and at the bottom of the bank’s official 1-per-cent to 3-per-cent comfort zone.

The Canadian economy is operating somewhere between 3 per cent and 4 per cent short of full capacity – an enormous output gap in historical terms. The unemployment rate in January was 9.4 per cent, up nearly four percentage points from prepandemic levels; there are 850,000 fewer people employed than there were before the crisis hit. The usual supply-and-demand forces that would push prices higher are, quite evidently, AWOL.

And yet when Statistics Canada releases new monthly consumer price index data on Wednesday, it will do so amid financial markets that have suddenly become obsessed with inflation. The surge in bond yields over the past two months amounts to a powerful message from the bond market: Inflation clouds are gathering.

The Bank of Canada, whose prime policy objective is to maintain stable inflation near its 2-per-cent target, doesn’t agree.

In a speech last week, deputy governor Lawrence Schembri acknowledged the year-over-year inflation rate could temporarily jump to near 3 per cent in the coming months, mainly because we will soon be measuring current prices against the slumping prices for many items in the depths of last spring’s pandemic shutdowns. But he insisted that it won’t last; the large excess supplies of production capacity and labour will bring a return to below-target inflation in fairly short order.

The message from the U.S. Federal Reserve – the world’s most powerful central bank, and the one most critical to bond markets – is substantially the same.

This difference of opinion underlines a key issue as we emerge from the pandemic. The actions taken to combat the crisis, taken together, have exposed the economy to risks of accelerating inflation – even as the crisis itself has had the opposite effect. As the economy prepares to reaccelerate, no one can say for sure how these forces will play out.

“We’re struggling – as markets, as economists, as bankers, as politicians, as central bankers – to see, how does this exactly play through?” said Dave McKay, chief executive officer of Royal Bank of Canada, in an interview last week. “There are a lot of people saying, ‘How could this be anything but inflationary?’ And the central bankers are saying, ‘No, we’ve got this, we can manage this through a cycle.’ ”

“There’s a wide range of [possible] outcomes, and it’s hard to predict.”

In the near term, there are forces at play – primarily, the Biden administration’s US$1.9-trillion stimulus package in the United States, as well as the up to $100-billion that Ottawa has pledged for a Canadian recovery plan – that could close the still-gaping output gap much faster than central banks are forecasting. That could accelerate inflation before monetary policy, itself far out on a stimulative limb, can catch up.

But the more fundamental questions lie in the longer term. There are legitimate reasons to be nervous about the amount of government debt and money creation that have been added to the usual equation – and how that might ultimately alter the low and stable inflation environment in which the world’s central banks have operated for a quarter-century.

For most of the 1970s and 1980s, Canada’s annual inflation rate typically ranged between 5 per cent and 10 per cent, despite comparatively tepid economic growth. Fast-rising government debt, and the necessary expansion of the country’s money supply to pay for it, not only fuelled persistent high inflation that steadily eroded purchasing power and savings, but also eventually produced years of uncomfortably high interest rates for borrowers.

Five-year fixed mortgage rates approached 20 per cent in the early 1980s, and were between 10 and 15 per cent for most of the decade. What’s more, the perpetually high inflation had become entrenched in expectations among consumers and businesses, infecting spending decisions and wage demands, and the accompanying high interest rates piled onto government’s debt burdens – all of which contributed to the inflation snowball.

It had become a vicious circle for the economy. By the beginning of the 1990s, policy makers were determined to break that circle.

This was achieved by the central bank committing to and aggressively defending a low-inflation target (initially 3 per cent, eventually lowered to 2 per cent), at the same time as the federal government committed to aggressively eliminating its budget deficit. While those efforts contributed to a long recession in the early 1990s, they combined to effectively break the back of a two-decade inflation problem.

Once those underlying inflationary forces were tamed, central banks in Canada and elsewhere were able to lock into 2-per-cent inflation targets by adjusting their policy based on strictly cyclical inflationary forces. They only worried about inflation as a product of an overheating economy, and raised interest rates moderately to slow things down and dampen those price pressures. In recessions, they lowered rates, as both they and the general public were confident that monetary policy could be used to restimulate the economy without triggering excessive inflation. Those more pervasive, systemic inflationary forces simply haven’t been part of the calculation for the better part of a quarter-century.

Coming from this perspective, the Bank of Canada and its global peers have spent the past year much more concerned about the risk of deflation – falling prices – than inflation. The dramatic downturn caused by the widespread pandemic shutdowns created the danger of a downward spiral in prices that, if sustained for any significant period, would be severely damaging to hopes of a recovery. Deflation is a notorious killer of growth and investment, and central banks have learned to defend against it aggressively.

That we’re now seeing rising inflationary expectations in the financial markets is, many central bankers would argue, merely evidence that their efforts are paying off – bond traders have taken disinflationary bets off the table.

“That reflects confidence in the market that central banks are going to get inflation back to target. That’s a good thing,” Bank of Canada governor Tiff Macklem said in a news conference in late February.

Perhaps. But the unprecedented monetary expansion by which the central bank has been achieving that goal, together with massive debt-fuelled government spending, could swing the inflation pendulum too far. Now that we’ve revived those old inflation bogeymen of debt and money creation, can they be kept in check?

International Monetary Fund chief economist Gita Gopinath argued in a recent blog post that there are several reasons to expect that inflation can and will be kept in its cage. She pointed to continued structural forces in the global economy that are distinctly disinflationary – such as the globalization of goods trade, which has held up through the pandemic much better than many people had initially feared; and automation, which looks likely to have been accelerated by the crisis. She also pointed to central banks’ considerable credibility, built up over the past several decades, in maintaining low-inflation targets – which plays a critical role in keeping inflation expectations subdued.

These forces certainly dampened inflation in the decade following the 2008-09 global financial crisis – confounding predictions that first debt-financed fiscal stimulus, then quantitative easing by the Fed and several other leading central banks, then record-low unemployment rates in the U.S. and Canada, would set off an inflationary surge.

This is one of the most popular counterarguments to today’s inflation fears: that it didn’t happen last time, so there’s no reason to think it will happen this time. The QE experiment in the global financial crisis set a precedent that central bank balance sheets can swell without bringing inflation.

But William White, who was a deputy governor at the Bank of Canada in the inflation-slaying days of the early 1990s, cautions that what worked safely in the past may not do so again in the future.

In a recent webcast by the Global Risk Institute, Mr. White argued that central banks have been abetted for years by disinflationary forces – globalization, technology, demographics – that have enabled low interest rates and money-supply expansion. That shouldn’t be mistaken for a permanent state of subdued inflation.

“Now, we have a situation where you’ve got the build-up of all these forces,” he said. “You simply can’t extrapolate past performance into future performance.”

“What comes next? The honest truth is ... nobody knows,” he said.

“I think it was Mark Twain who said, ‘It ain’t the things that you don’t know what gets ya. It’s the things what you know for sure what ain’t so.’”

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