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What triggered the sharp rise in Canadian inflation in spring 2021 is still a matter of debate. And it’s a debate that matters: the relative importance of the pandemic’s disruption of supply chains, Russia’s invasion of Ukraine, “greed,” or central banks’ financing of a surge in government spending will affect our response to future events. But once inflation gets started the initial causes are less important than the process that sustains it, which is a combination, on the one hand, of rising inflation expectations and costs and, on the other, of inadequate production.

When inflation has been low and stable — say two per cent — for some time then everyone knows that everyone knows that inflation will be about two per cent and behaves accordingly. It’s common knowledge. But when something disrupts that stable behaviour — a pandemic, a war, a big increase in government spending with deficits financed by central bank bond purchases — people’s behaviour changes.

First comes the response in markets with flexible prices: oil, copper, lumber, wheat and other commodities in high demand. As raw materials prices rise, processors and manufacturers who use them raise their prices to cover their increased costs. If the inflationary shock arrives at a time when aggregate demand exceeds aggregate supply, as it did in Canada in 2020-21, the initial shock is passed through to prices of other goods and services. (If there’s excess supply in the economy, the price increase is muted or takes the form of a slower reduction in prices than would otherwise have taken place.)

When there is this excess demand, workers who see their real income and standard of living being reduced by rising prices respond, not surprisingly, by demanding higher wages to catch up.

If the rise in prices persists, common knowledge and expectations begin to change. Every business knows that other businesses are raising prices to maintain their profitability. Every worker knows that other workers are asking for a faster pace of wage gains and are changing jobs, if need be, to get them. That is the situation we currently find ourselves in. Common knowledge has changed and inflation expectations appear to have increased to well above the stable two per cent target we grew accustomed to between 1995 and 2020.

Inflation gathers momentum when total compensation per worker outpaces the growth of output per worker, or productivity. A useful measure for capturing this relationship is growth in unit labour costs. When inflation picked up in the 1980s, compensation per hour outstripped productivity and unit labour costs grew by as much as six per cent per year. The 1990-91 recession pushed up unemployment and slowed wage growth, and productivity rose as the economy recovered, driving unit labour costs down. From 1992 through 2019, growth in unit labour costs averaged around 1.5 per cent per year, while inflation stayed close to the Bank of Canada’s two-per cent target — a stable process supported by expectations of two per cent inflation and modest, but positive, gains in productivity.

The recent inflationary shock pushed Canada back into a situation more like the 1980s. Compensation is rising, but productivity is not. Unit labour costs have grown an average of 4.8 per cent a year since the end of 2019. At the end of last year, the latest data show, compensation per hour was growing at a 5.2 per cent pace while productivity was falling at a 1.5 per cent pace, resulting in unit labour cost tearing along at 6.7 per cent. No wonder core CPI is up!

Breaking the momentum of Canada’s inflation will require some combination of slower compensation growth and faster productivity growth. Neither will be easy, and the inflationary late 1980s and recessionary early 1990s are both episodes we would like to avoid. Milder restraint of demand than took place in the late Mulroney years, combined with policies that boost investment and productivity, could hit the economic sweet spot of re-booting expectations without a recession.

The Bank of Canada has been restraining demand with higher interest rates. But recent federal and provincial budgets have done more to stoke demand with higher spending and borrowing than to boost productivity with investment-friendly tax and regulatory relief. For inflation to return to two per cent, fiscal and regulatory policies need to do more to ensure the faster productivity growth that will help break inflation’s momentum.

Op-ed from the Financial Post

Ted Carmichael is a member of the C.D. Howe Institute Monetary Policy Council.​