The Absurdity of Canada’s Inflation Control Strategy
The Absurdity of Canada’s Inflation Control Strategy
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The opinions expressed here are those of the author alone and do not represent the views of any associated entities.
Back when I worked on Bay Street as an Interest Rate Strategist I used to struggle to explain what I did for work. My job was to design interest rate-based trading strategies. Most people had no clue what this meant because they were unfamiliar with interest rates, which had been so low for so long, that they had become effectively irrelevant.
Things have changed drastically over the last year. High inflation and interest rates have put pressure on our wallets, and are now top of mind for many Canadians.
But have you ever stopped to consider what exactly is going on? Why are interest rates elevated? Why is inflation high? What’s the plan to get it back under control?
Today we’ll take a step back and dig into these seemingly basic questions. I think the answers will surprise (and maybe even scare) you.
According to Investopedia, “Inflation is a rise in prices, which can be translated as the decline of purchasing power over time”.
In simpler terms, inflation is when your money doesn’t go as far as it used to.
We’ve certainly experienced some serious inflation over the last couple of years. The below picture of a $34.40 uncooked chicken at a No Frills in Toronto was recently posted on Reddit. (My favorite comment on this post: “Looks like you found a frill.”)
Shocking prices like this resulted in decades-high readings by Canada’s gauge of inflation, CPI (Consumer Price Index), starting last year. In response, the Bank of Canada, the organization responsible for keeping inflation low and stable, raised interest rates.
When you think about it, doesn’t this response to elevated inflation seem strange? How would higher interest rates, which make borrowing more expensive, combat inflation?
Here’s how Tiff Macklem, the head of the Bank of Canada, explained it in a discussion last year:
“... I just want to assure everybody that we understand that businesses, households, they're facing higher costs for groceries, for fuel, for gasoline, for many items. For businesses, many of your input costs have gone up. And it can seem counterintuitive that raising borrowing costs, raising interest rates is going to help you. We're raising our borrowing costs when you're already facing higher other costs. But that's the way monetary policy works. By raising borrowing costs, we will slow spending, give supply some time to catch up, and that's what's going to take the steam out of inflation.
So, there is a sense in which there's some short-run pain for long-run gain. And the long-run gain is we get back to more normal price changes—low, stable, predictable inflation—and so that you don't have to worry about what everything's going to cost next week, next month, next year.”
Theoretically, prices rise and fall according to the balance of supply and demand. Our strategy to deal with prices rising too quickly (i.e., elevated inflation) is to reduce demand by making it harder to fund purchases through borrowing (i.e., with debt).
The idea is to make it harder to afford stuff, so that less stuff will be purchased, and prices will stop rising so quickly. Seems like a pretty crude, indirect, approach, doesn’t it?
It’s also cruel. There probably weren’t many people buying much more food than they needed, yet we aimed to reduce demand for everything. Our strategy is working as expected: it’s harder to afford food, and food bank usage has jumped by 60% over the last year.
When it comes to inflation, we only focus on one side of the supply and demand equation
Our strategy is to slow price growth by reducing demand. But is this really the best way to deal with inflation that is largely a result of supply disruptions?
The Bank of Canada began raising interest rates last year in response to the rising cost of goods such as cars, fuel, and food. These prices were rising, for the most part, because of supply issues, not high demand. A variety of factors related to the pandemic, weather, and geopolitical turmoil resulted in limited oil and gas, supply chain disruptions, factory closures, and poor harvests, all of which helped to drive up prices.
An effective approach to deal with inflation resulting from supply disruptions would be for the government to step in and help alleviate stress on supply chains through targeted loans, subsidies, tax incentives, or other programs. However, since Canada has become completely reliant on other countries, importing just about everything, we have no way of doing this. Unable to influence supply, we are left with no choice but to disrupt demand and hope that the supply disruptions eventually resolve.
Raising interest rates will decrease demand, resulting in lower prices…?
This assumption underlies our inflation control approach, but it does not always hold true.
For certain necessities, for example, food, demand can only fall so far because people will pay whatever they must to eat.
Additionally, market structure plays a role in determining how prices respond to demand pressures. Canada’s economy is dominated by monopolies and oligopolies. In our highly concentrated markets, prices are driven less by demand, and more by how much the monopolist thinks they can charge without causing an uproar.
Consequently, industries that have been monopolized and sell necessities are especially unlikely to respond to higher interest rates with lower prices.
The grocery market is a great example of how all of this plays out in the real world. Despite interest rates rising over the course of 2022, Loblaws had its most profitable year on record, and food prices are still aggressively rising.
Our inflation control approach doesn’t account for its most pronounced impact
As we discussed last time, The Bank of Canada managed to do the unthinkable - cool off one of the world's hottest housing markets - by raising interest rates. But they rarely ever mention this because the housing market slowdown was an accidental side effect of efforts to deal with the rising cost of day-to-day purchases. The Bank of Canada does not take home prices into account when making decisions about interest rates.
Most people would agree that when trying to lose weight, you shouldn’t just starve yourself.
That might work, but it would be better to actually get to the root of the problem. Maybe clean up your diet, or become more active.
Trying to control inflation with interest rates is akin to a starvation diet. We attempt to use this blunt tool to reign in prices by decreasing demand, in situations where prices do not respond to demand, or where supply is the real issue. All the while, we ignore the effect of interest rates on the housing market, where their impact is the most pronounced.
We need to rethink our inflation management strategy.
That’s all for this time.
As always, I would love to hear any thoughts, comments, or concerns you might have about all of this. Feel free to reach out!
Thanks for reading,
Kareem