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November 3, 2020

Last week’s quarterly “Monetary Policy Report” (MPR) from the Bank of Canada sketched the long and likely winding road Canada’s economy needs to travel before it gets back to where it was pre-pandemic. And, with it, the long road inflation will have to take to return to its target rate of two per cent.

At the same time, the bank announced it would hold the target overnight rate of interest at its effective lower bound of 25 basis points (i.e., 0.25 per cent), “until economic slack is absorbed so that the two per cent inflation target is sustainably achieved,” which the bank estimates will not happen until sometime in 2023.

This amounts to “forward guidance” about the path of the overnight rate target — an effort to reduce policy uncertainty that in theory will help keep longer-term interest rates low, boost spending and put upward pressure on inflation. In September, so-called headline inflation was running at an annual rate of 0.5 per cent, well below the two per cent target.

With many sectors of the economy impeded by compulsory lockdowns and restrictions, however, headline inflation is a potentially misleading measure of the rate of change of the cost of living. Which is why in July, Statistics Canada and the bank introduced an adjusted CPI inflation index reflecting the drastic changes to consumption patterns the pandemic has caused. But this new index has only been marginally above headline inflation, including its most recent reading (from August) of 0.4 per cent — versus 0.1 per cent for headline inflation. That is more inflation than the standard measure implies but 0.4 per cent per year is a long way from target.

There are many reasons to think it will be a while before inflation starts to rebound: restrictions that will keep demand subdued, weak business investment given all the uncertainty around the virus and lost jobs at the bottom of the income distribution — where people typically spend a higher percentage of their income.

Cautious economists are always looking at the other side of the coin, however. So we ask: are there any reasons to think inflation could move towards two per cent faster than the bank predicted in its announcement? The short answer is yes, with some of the reasons for thinking so to be found in the bank’s own statistics and publications.

First, the bank’s three different measures of core inflation, which abstract from the more volatile components of the consumer price index, are already running at close to two per cent. In fact, the so-called “CPI-median” measure, currently at 1.9 per cent, has not dipped below 1.8 per cent since the beginning of the pandemic. All three measures suggest the weakness of headline inflation may be temporary. Its fall has been driven by big drops in a few items, most notably energy, that make up a large portion of the CPI basket.

Second, the MPR included a substantially lower estimate of the economy’s potential output since the bank’s last estimates in April 2019. By the end of 2022, the bank thinks potential output will be three per cent lower than it had expected in the April 2019 MPR — mostly because of weak business investment, but also from lower labour market participation and disruptions to immigration. That implies, other things equal: smaller potential supply, a smaller output gap (the difference between actual and potential output) and therefore greater upward pressure on inflation.

Third, the bank’s balance sheet has grown at an unprecedented pace since the beginning of the pandemic. The rate of growth has flat-lined of late, as continued increases in government bond purchases have been offset by the end of measures it took early on that succeeded in stabilizing financial markets. In last week’s announcement, the bank said it will reduce its total asset purchases from at least $5 billion per week to at least $4 billion per week, with a shift towards assets with longer maturities.

Still, all of the bank’s recent bond-buying has translated into a 27.6-per cent growth in the money supply — technically, in “M1+,” which is mostly cash in circulation and chequing accounts — in the 12 months to September. That’s the biggest increase since 1985. Current slack in the economy means this jump in the money supply does not threaten an immediate increase in inflation, but money growth as fast as that has to raise longer-term concerns. Pure monetarism went out of style in economics a few decades ago, but that much more money chasing fewer goods and services, as potential output declines, is cause for inflation worry. In the end, something has to give.

The bank’s promise to keep the overnight interest rate at 25 basis points, its effective lower bound, is only conditional. That gives it an opening — should economic slack shrink and inflationary pressures rise — to raise interest rates before 2023. That would be bad news for our governments, which have taken on massive new debts to help bridge us through the worst of the crisis, but a good-news sign for the rest of us that the recovery was stronger than anticipated — which in the long run may be how we deal with those debts.

Published in the Financial Post

Steve Ambler, a professor of economics at the Université du Québec à Montréal, is the David Dodge chair in monetary policy at the C.D. Howe Institute, where Jeremy Kronick is associate director of research.