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If there’s a single phrase that defines 2021, it could be 'supply chain problems.'Frank Gunn/The Canadian Press

Central banks are preparing to launch a war against inflation, but the terms of engagement have changed markedly from past economic cycles.

Welcome to the battle against supply driven inflation. Before it’s over, it may force our monetary policy-makers into some unfamiliar and uncomfortable choices.

“Unlike when inflation is driven by demand, policy cannot stabilize both inflation and growth at the same time. It has to choose between them,” the research team at BlackRock Investment Institute said in a report last week.

If there’s a single phrase that defines 2021, it could be “supply chain problems.” The COVID-19 pandemic, and the rapid reopening of much (but not all) of the economy after public health-mandated shutdowns, put severe and unexpected strains on supplies across wide swaths of the economy. Most experts identify this as the primary cause of the multidecade highs in inflation in Canada and many countries.

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Next Wednesday, both the Bank of Canada and the U.S. Federal Reserve will announce interest-rate decisions, with pressure mounting on both to start raising rates to combat inflation that has now reached 4.8 per cent in Canada, and 7 per cent in the United States. (The Fed looks likely to hold its rate steady, while sending a strong signal that it will launch increases in the spring. For the Bank of Canada, it’s now looking like a coin toss whether it will start raising rates now, or clear the path for March hikes.)

Some critics charge that central banks have been asleep at the wheel during this inflation run-up, clinging to a misguided belief that the price spike was transitory and would fade on its own. Others have argued that rate hikes are the wrong tool for the job, as they are designed to cool excess demand, not fix a lack of supply.

The BlackRock researchers say it’s more complicated than that. They argue that inflation from supply disruptions reflects an entirely different economic condition than the inflation that central bankers are used to addressing, which fundamentally alters the equation for rate hikes.

Report co-author Jean Boivin, head of BlackRock Investment Institute and a former Bank of Canada deputy governor (2010-2012), summed up the distinction in a tweet on Friday: “If inflation is the noise from the economic engine, in the past it was caused by the engine revving too fast. For the foreseeable future, it is more likely to be due to the engine misfiring.”

In a typical cycle, inflation starts to build when growing demand threatens to exceed the maximum capacity to produce supply. The job for central banks in this situation has been well understood for decades: raise rates to slow that demand and, thus, cool inflation. When you get it right, you can maintain both relatively low inflation (2 per cent is the goal of most central banks, including Canada’s) and an economy running close to full capacity.

But in the current recovery, inflation far overshot 2 per cent in economies running well below full speed. In the United States, employment is still about 3.5 million jobs short of where it was before the pandemic. In Canada, the job recovery has been stronger, but gross domestic product – the broad measure of total economic activity – still hadn’t recovered to its prepandemic level as of October (the latest figures available).

Yet the supply issues have pushed inflation to the point where central banks have no choice but to take action. To argue that interest rates are the wrong tool for the problem is misguided. Regardless of the cause, higher rates will, nevertheless, absolutely reduce inflationary pressure – by slowing demand.

“But when supply constraints are responsible for higher inflation at a time when the economy is not yet back to full capacity, there is a difficult choice to be made: either live with higher inflation or destroy activity before reaching full capacity,” the BlackRock report said.

By waiting as long as they have, policy-makers have opted to accept higher inflation in exchange for more economic recovery – because the opposite would have been, frankly, unacceptable. The BlackRock researchers calculated that, had the Fed opted to raise rates to keep inflation near 2 per cent throughout the pandemic restart, the U.S. unemployment rate would have languished above 10 per cent, rather than falling to its current 3.9 per cent.

But now, central banks are preparing to start raising rates before they normally would have, had they had the luxury to wait until employment and output had reached full potential. (Though in Canada’s case, employment may now be very close to its peak, even if output is still well short. One out of two is going to have to be good enough for the Bank of Canada.)

As policy-makers continue to raise rates over the next year or two, they’ll have to decide how much growth they’re willing to leave on the table to get inflation back into its cage. Those decisions will determine how high rates go, and how quickly – and how successful they are at returning to the 2-per-cent target.

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