Probably the most confounding puzzle of the post-financial-crisis economic recovery, in Canada and elsewhere, has been the persistent shortage of inflation. But there has been no shortage of attempts by economists to explain the phenomenon.
Maybe it’s the impact of emerging technologies and artificial intelligence. Maybe it’s a consequence of trade liberalization. Perhaps the growth of online shopping is to blame, as consumers can instantly secure the lowest price.
It could be that the aging of advanced-economy populations has applied the brakes to consumption. Or maybe income inequality is a contributor, as middle-class spending power has stalled. Or, as some experts suggest, it could be that years of slow-growth inflation has simply lowered consumers’ inflation expectations – inflation is slower because everyone now expects it to be slower.
Now, researchers at Toronto’s C.D. Howe Institute have added to the mix their own possible explanation: It depends on who’s doing the inflating.
In a new study released Tuesday, authors Jeremy Kronick and Farah Omran argue that a key clue in the inflation riddle has been the breadth of economic growth at various stages in the post-crisis recovery. When inflation has been surprisingly tepid despite solid economic expansion, it has been when the growth has been concentrated in only a handful of sectors, while others have languished.
Further, the researchers say that in these slow-inflation periods, the sectors that have remained weak have tended to be those where lower-income Canadians spend more of their income – such as utilities and housing and food. Since lower-income households typically spend more of their disposable income than high-income households, the weakness in these sectors has amplified the dampening effect on inflation.
In some ways, the findings are no big surprise. Economists at the Bank of Canada (and elsewhere) have always been aware that inflation tied to narrowly based economic growth tends to be unsustainable across the broader economy. Additionally, that a wise central banker should look through single outlier sectors that temporarily distort the inflation numbers.
The Bank of Canada has even become more sophisticated in this regard over the past couple of years, having introduced three new gauges of so-called “core inflation” in an effort to filter out distortions around the edges of consumer inflation and bring the underlying inflationary pressures common to the entire economy into sharper focus.
It’s also why income growth has also been such a key indicator of inflationary pressures for the Bank of Canada in the post-crisis cycle. Broad-based growth – and an economy closing in on full capacity not just in a few sectors, but across the breadth of the economy – typically fuels broad-based income growth, which both feeds into consumer demand and motivates producers to pass their rising costs on to consumers, thus stimulating inflation.
Still, the C.D. Howe research may provide some useful direction for analysis of inflationary pressures as central bankers try to gauge interest-rate policy over the relatively near term. Consider, for example, what Canada’s current inflation picture is telling the Bank of Canada as it prepares for its next rate decision on Wednesday.
Canada’s inflation rate surged in May to 2.4 per cent – putting it substantially above the Bank of Canada’s long-standing target of 2 per cent. The bank’s three core measures are more muted, indicating that some narrow, temporary forces are at work, but they nevertheless averaged an above-target 2.1 per cent.
The breadth of the price gains is solid, though not overwhelming: All eight major components are up year over year, but only half of them are growing above the 2-per-cent target. But the strongest year-over-year price gains are in food, transportation and shelter – all of which are sectors in which lower earners are more sensitive.
The May inflation report supports what the Bank of Canada has been saying – that relatively broad-based growth has resumed after a lull, and that the economy is approaching full capacity. While the bank has its reservations about risks in the outlook – such as the U.S.-China trade dispute and the possibility of slowing U.S. growth – the inflation picture certainly suggests that the Bank of Canada is in no need of a rate cut any time soon, despite expectations that its U.S. counterpart is nearing a cut of its own.
In the bigger picture, the findings also speak to the post-crisis concerns about income inequality – specifically, that the wealthier extremes of the population have disproportionately benefited from the recovery. Statistics Canada data show that from 2012 to 2015, real (inflation-adjusted) incomes of the top 0.1 per cent of income earners in Canada rose by 17 per cent, while real incomes of the bottom 90 per cent of earners rose just 2.2 per cent. The C.D. Howe research supports arguments that more broadly based income growth may lead to a healthier economy – with stronger growth and, correspondingly, sustainable, healthier inflation.
David Parkinson