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Since the start of this year, inflation has been running at an annualized rate of 5.4 per centAdrian Wyld/The Canadian Press

Is it time to panic about inflation? The latest figures would suggest at least a degree of alarm is in order. September’s year-on-year increase in the consumer price index, at 4.4 per cent, was the highest recorded since 2003, and more than double the Bank of Canada’s target of 2 per cent that for 30 years has been the norm.

Of course, that measures where inflation has been, not where it is going. Here, opinion divides into two camps. On the one hand are conservatives of the Pierre Poilievre school, for whom the answer is as simple as the quantitative theory of money: massive federal deficits, financed in large part by Bank of Canada purchases of government bonds, not only explain current inflation, but predict much higher inflation to come.

On the other hand are the government and its supporters, for whom the answer is: relax. Not only is current inflation nothing to worry about – a short-term trend, mostly due to kinks in global supply chains and other one-time factors, exaggerated by the artificially depressed level to which prices fell last year – but so is future inflation. Similar massive expansions of central-bank balance sheets in response to the 2008 financial crisis – a policy known as “quantitative easing” – did not result in the runaway inflation some predicted; neither will this.

The truth, as is so often the case, lies somewhere in between. It’s true that the price increases observed over the past year have less to do with domestic monetary policy and more to do with temporary influences – take out gas prices, for example, and September’s number drops to 3.5 per cent. But we’re long past the stage when it’s useful to talk about “base effects.” Since the start of this year, inflation has been running at an annualized rate of 5.4 per cent (4.6 per cent seasonally adjusted).

It’s true, likewise, that quantitative easing did not lead to higher inflation in the recent past. That does not mean it will not do so in future. What the post-financial crisis experience demonstrated is that inflation is not a simple, straight-line function of the supply of money (it also depends, among other things, on the demand for money). But that does not mean there is no relationship between the two.

So while the pace of inflation over the past year may indeed be largely explained by one-time factors, there is still room for concern at where it may be headed in the months and years to come. As it is, central bankers in Canada and abroad have had to revise their predictions about how “transitory” the surge in inflation would prove. More worrying still, evidence is accumulating that current inflation is starting to get baked into expectations of future inflation.

This, too, should not be overstated. Yields on 10-year government bonds may have more than doubled since the start of the year, but remain at just 1.7 per cent. More troubling, nearly half of respondents in the Bank of Canada’s latest quarterly business outlook survey expected inflation to average more than 3 per cent over the next two years. Should expectations continue to rise – should inflation continue to prove not so transitory as advertised – policy makers will have a problem on their hands.

We should be clear on what the nature of that problem is. One-time spikes in prices do not, by themselves, cause permanent increases in inflation; neither do expectations. In the long run, inflation remains a function of the supply of money, which means it is within the power of central banks to control. But expectations can affect how costly that effort will be, in terms of output and employment.

The key is to keep expectations of inflation in line with actual inflation. Recessions happen when the two get out of whack – when price- and wage-setters expect inflation to be higher than it in fact turns out to be. If, for example, inflation is expected to be 6 per cent but comes in at 2 per cent, the result will be an unexpected 4-per-cent increase in real wages – and a sharp rise in unemployment.

Central-bank credibility is therefore crucial. If the Bank of Canada says inflation next year will fall from 4 per cent to 2 per cent, and the public believes it, the adjustment to disinflation will be relatively smooth. If the public does not believe it, it will be more agonizing and protracted.

The higher the cost of fighting inflation, the more reluctant central banks might be to act against it; and the more people doubt central banks’ willingness to act, the more they will be inclined to believe inflation will go on rising – and behave accordingly.

We can still avoid getting caught in this spiral. Thirty years of low inflation has earned the Bank of Canada a great deal of credibility. But it is starting to erode. Whether it deteriorates further will depend on what happens next.

The extraordinarily loose fiscal and monetary policies pursued over the past 18 months may not have ignited inflation while the economy was flat on its back, and held there by government-ordered lockdowns. But now that the lockdowns have been lifted, and the economy is recovering, there is real risk of an inflationary blow-off.

Escaping that fate will require reductions in both the government’s issuance of debt and the Bank of Canada’s purchases of it. Fortunately, both seem to be in the works. The federal deficit has already been cut, from $335-billion last year to a projected $138-billion in fiscal 2022, and it seems to be heading lower, especially after this week’s decision to discontinue the main pandemic aid programs.

Bank of Canada bond purchases, meanwhile, have been reduced from $5-billion a week at the height of the pandemic, to $2-billion currently; the central bank is poised to announce a further reduction, to $1-billion.

Have either acted soon enough, sharp enough? More important, will the public see this as enough to prevent inflation from rising further – and adjust their expectations accordingly? If so, then we may yet avoid the bleak future of higher inflation, rising interest rates and escalating government debt the pessimists foresee.

If not, then the time may indeed be coming when a little panic is appropriate.

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