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One data point does not make a trend. Still, the news that the rate of inflation, as measured by the year-over-year increase in the consumer price index, fell to 7.6 per cent in July from 8.1 per cent the previous month had to be somewhat cheering to the Bank of Canada – the first decline after more than a year of unrelenting acceleration.

Inflation is still far too high: higher than it has been for 40 years, and nearly four times as high as the bank’s 2-per-cent target. But much of current measured inflation is due to increases in commodity prices – always volatile, they have been particularly vulnerable to pandemic- and war-related disruptions in supplies. With these in retreat, it is likely that the headline rate of inflation will continue to fall in coming months.

This leaves the bank in a peculiar position. Having spent most of 2021 arguing – wrongly, as it turned out – that the rise in inflation was transitory, it must now make much the same case about the fall in inflation. Overall inflation may be in decline, but strip out the most volatile components and “core” inflation is still running at more than 5 per cent. Which most likely means more steep increases in interest rates in coming months.

No wonder the governor, Tiff Macklem, has been so active in the media of late. He needs to convince people that, in the long run, inflation will fall all the way back to 2 per cent – but that in the short run it will not fall as quickly or as easily as all that.

Or in other words, months of hard slogging are ahead: maybe even a recession. Ah, but must there be a recession, though? This is the focus of much recent debate among economists. Can the bank bring the economy in for the proverbial “soft landing,” or does grounding inflation inevitably require nose-firsting the economy?

The hard landing school admittedly have history on their side. Central banks have rarely succeeded in killing inflation without at least maiming economic growth: just once, in the case of the U.S. Federal Reserve, in nine tries. But past performance is no guarantee of future results. Just because disinflation has most often come at the cost of recession historically does not mean it must always do so.

Today’s economy, for example, is less reliant on manufacturing than in the past – just 10 per cent of GDP, versus 30 per cent in the early 1950s. So it is much less exposed to swings in the inventory cycle – accumulations of unwanted inventory in the early stages of recession, shed only by deep and prolonged cuts in production.

Then there is the role of expectations. Much of what actually happens in an economy depends on what people expect will happen – or rather it depends on how closely the one conforms with the other. If people expect inflation to fall, they will reduce their own wage and price demands accordingly: Instead of demanding to be compensated for 8-per-cent inflation, they need only ask for two. Provided inflation falls in line with expectations, there need be no impact on output.

If, on the other hand, they act in the expectation of 8-per-cent inflation and it falls to two, they will find fewer takers for what they are selling: In real terms, their price or wage will have increased. To avoid such dislocation, then, it is critical that expectations be aligned with policy. Wage and price setters have to guess correctly what policy makers have in mind – but, equally critically, policy makers have to guess correctly what people expect.

There is an age-old debate in economics about how inflation expectations are formed. Do people, in essence, form their expectations by looking back – that is, do they expect future inflation to be some function of what it was in the past? Or do they incorporate whatever other sources of information might be relevant – including their guesses about policy makers’ intentions?

Of course, the one may well be informed by the other. Suppose policy makers promise to cut inflation from 8 per cent to 2 per cent. It will surely be relevant, in assessing the credibility of this promise, how successful policy makers have been at delivering on similar promises in the past.

And this is what might make the current effort to squeeze inflation out of the economy different from past exercises. Because the current bout of inflation, uniquely, comes after 30 years in which central banks both promised and delivered low and stable inflation. Indeed, from 1991, when the Bank of Canada began formally targeting inflation, through 2019, the monthly annualized rate of inflation remained within its target range more than 80 per cent of the time.

It is vital to understand how rare – how unprecedented – an achievement this is. Prior to the establishment of the bank in 1935, prices fluctuated wildly, as did output, from inflation to deflation and back again. Instability remained the norm for some years afterward – understandably, given the challenges of navigating through the Depression and the Second World War.

Still, at least people knew what to expect. The explosion of inflation after the war ended was followed by an equally rapid disinflation, just as inflation and disinflation had always followed other wars throughout history.

By contrast, the period of sustained, accelerating inflation that began in the mid-1960s, peaking in the early 1980s, was something new. Historical experience offered no guide. People could only rely on what they were currently experiencing – high and rising inflation, year after year, in the face of the authorities’ repeated promises to bring it to heel.

The lesson evidently sank in. Even the recession that launched the decade offered only a brief reprieve: Inflation soon began accelerating again. It took yet another crunching recession, and the adoption of price stability as the sole and explicit objective of policy, to persuade people that low inflation was here to stay.

The question, then, is: Is this the early 1980s all over again? Or is it more like 1945? Will people take the last year or so of surging inflation as the new normal, and bake higher inflation into their expectations? Or will they see it in the context of the preceding 30 straight years of low and stable inflation – as the exception, born of exceptional circumstances, rather than the rule? Will they conclude that, in the long run at least, inflation is indeed transitory?

So far the evidence is mixed. Surveys of consumer expectations of inflation show a decline. Credit markets, measured by the gap between the returns on conventional bonds and their “real return” (i.e. inflation-adjusted) cousins, are expecting inflation to average less than 2 per cent over the longer term. Wages, on the other hand, may prove harder to crack.

Over all the situation is much as Churchill famously described, after El Alamein. “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

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