From: Miville Tremblay
To: Canadians Worried about Inflation
Date: June 7, 2021
Re: Why We Need Expectation Anchors to Keep Inflation at Bay
When it comes to inflation, crying wolf may cause the beast to emerge for real. If everyone believes in it and acts that way, inflation can appear.
Conversely, if all economic actors believe that inflation will remain on average at 2 percent, there is a good chance that it will come to pass. Hence, for a central bank, the critical task is anchoring expectations.
The economy is always buffeted by tailwinds or headwinds that push inflation up or down. But if expectations are properly anchored, only minor changes to the Bank of Canada’s key rate are necessary for inflation to return to target.
On the other hand, if doubt undermines the credibility of the central bank, it will have to act with greater force to be taken seriously. When inflation was soaring and central bankers' reputations were in tatters, it took tough guys like Fed chair Paul Volcker in the early 1980s and Canada’s John Crow 10 years later to quell double-digit inflation, at the cost of severe recessions.
Inflation in April – 3.4 percent in Canada and 4.2 percent in the United States – surprised by its magnitude, even though low oil prices at the start of the pandemic a year earlier created an unusually low benchmark.
Suddenly, the markets sounded the alarm, with the stock market down and bond yields up. However, a closer examination of expectations shows that the concern, still real, remains contained.
A closely watched technical indicator, breakeven inflation, which measures the spread in yields between regular and real return bonds, suggests that the US market is forecasting average inflation of 2.8 percent over the next five years and 2.4 percent for the following five. No reason to write home to mother.
Both the Fed and the Bank of Canada invite us to look beyond the next few months, beyond the temporary factors of an economy in post-traumatic shock.
Those temporary factors include production, which remains on hold in many sectors and supply chains that are still disrupted. There are bottlenecks, such as containers, which are scarce in some places.
Furthermore, demand is rebounding more sharply than production, which will take time to adjust. You can see it in the price of raw materials, especially lumber, which has skyrocketed.
Government payments to people on layoff and consumption bottlenecks during the pandemic have inflated personal savings. Post-pandemic consumers, like loggers who arrive in town after a winter in the woods, will be spending wildly.
Several countries are grappling with labour shortages even as high unemployment persists. In Montreal, we see restaurateurs offering salary increases in the kitchen to attract staff who have found a job elsewhere or who still fear illness. The low participation in the labour market is indeed the main reason why central banks are keeping interest rates low.
All of this suggests inflation will be between 2 and 3 percent this year.
The more interesting question is what will happen in the longer term. On the one hand, the deflationary pressure created by 20 years of trade with China has paid off. But the redeployment of production chains might reverse some of those gains.
On the other hand, we can hope that massive investments in digital technologies will finally allow productivity gains to put downward pressure on prices. But for a long time, we have been waiting for the increase in productivity as we waited for Godot, who never comes.
Authorities have a delicate turn to negotiate. In Canada, they are preparing to slowly reduce fiscal and monetary stimuli. The Bank has already cut its bond purchases and moved 2023 closer to the second half of 2022 as the right time for a key rate hike. Markets see it as early as this fall.
In the United States, they do not expect a rise until the start of 2023, a year ahead of the Fed’s forecast. And Joe Biden is still trying to push big bucks through Congress to help families and invest in infrastructure.
Democratic Party ally, economist Larry Summers, is crying loudly about inflation. This fear is being shared by the markets, which has depreciated the greenback against other currencies, including the loonie which, moreover, is supported by the rise in commodities.
Am I worried? It’s a tough game, but I take comfort in knowing that central banks can draw on the capital of credibility built up in 30 years of keeping inflation in check. This capital was bought dearly and I’m certain the Bank will not squander it by letting inflation run wild.
Miville Tremblay is a Senior Fellow at the C.D. Howe Institute and a former senior director of the Bank of Canada.
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The views expressed here are those of the author. The C.D. Howe Institute does not take corporate positions on policy matters.
A version of this Memo first appeared in La Presse.