Shoppers at the Toronto Eaton Centre on July 18.Fred Lum/The Globe and Mail
In analyzing the causes of high inflation in Canada, many experts point to interest rates that were too low for too long, along with surging commodity prices.
But Canadians may want to consider another culprit: their neighbours to the south.
In a recent working paper, three researchers at the U.S. Federal Reserve dissect the role of fiscal stimulus in today’s inflation shock. They note that a “generous” response to the pandemic, particularly from the U.S. government, led to an increase in demand for goods that was not matched by supply – and ultimately spilled into other countries.
For Canada, the knock-on effects were sizable. The annual inflation rate in February, 5.7 per cent, was about four percentage points higher than in recent history. Of that “excess inflation,” U.S. fiscal stimulus contributed about 2.3 percentage points, the Fed researchers estimate, pointing out that the impact was much bigger in Canada than elsewhere.
“Canada, a country with strong trade links with the U.S., features a high level of excess inflation related to exposure to foreign fiscal stimulus,” they wrote.
The flare-up in consumer prices is only worsening. Canada’s inflation rate hit 7.7 per cent in May, the highest in almost four decades. Bay Street analysts expect it to be even higher when June figures are published Wednesday. U.S. inflation hit 9.1 per cent in June.
Central bankers are now trying to tame inflation with the quickest pace of monetary policy tightening in decades, notably through a series of interest-rate hikes. The Bank of Canada has raised its key rate to 2.5 per cent from 0.25 per cent in less than five months, and bank officials have signalled that more hikes are coming.
“There is clearly a large component of Canadian inflation that is being driven by the overheated nature of the American economy,” Royce Mendes, head of macro strategy at Desjardins Securities, said in an interview. “The fiscal response was huge, but the delay in reining in monetary stimulus also played a large factor in this as well.”
Like other countries, the U.S. moved quickly to launch pandemic support programs and blunt the financial impact on households. Government spending played a “positive role” during the crisis, the Fed researchers wrote, by supporting a strong economic recovery and likely preventing “worse outcomes.”
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The U.S. response was especially large. It spent more than US$5-trillion, or roughly 25 per cent of gross domestic product – proportionally more than most countries.
U.S. stimulus was often paid directly to households. Families could receive three rounds of cheques – regardless of whether their employment was affected by the pandemic. An individual with an annual income of less than US$75,000 could receive US$3,200.
Flush with cash, Americans started loading up on goods, in part because they had fewer options for spending that extra money on services. A speculative mania swept through various asset classes, from stocks to sneakers.
At the same time, businesses couldn’t keep up with demand, with factories and ports often shuttered by public-health measures, leading to supply chain issues that drove up prices.
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The Bank of Canada consistently underestimated the inflation threat and said about a fifth of its forecast error was related to global supply chain pressures, including the extent to which people bought goods.
“Instead of weakening as in past downturns, U.S. consumer demand for goods unexpectedly surged well beyond pre-pandemic levels. Supported by fiscal policy measures, U.S. household incomes turned out to be higher than anticipated,” the bank said Wednesday in its monetary policy report.
“Overall, strong foreign demand for tradable goods, such as appliances and furniture, has pushed up prices globally, including for Canadian consumers.”
The Fed researchers outlined three ways fiscal stimulus affects prices. Canadians are paying more for U.S. goods as American companies struggle to keep up with scorching demand. Likewise, Canadians are paying more for products from non-U.S. countries that have seen a boost in American demand. And finally, Americans are ordering more Canadian goods than usual, contributing to the supply-demand imbalance seen at home.
“When we are competing for goods or some services on the global stage, and we’re competing with an extremely strong U.S. economy, we’ll have to pay up to get our fair share of those goods and services,” Mr. Mendes said.
There are, of course, many explanations for the surge in inflation. Rock-bottom mortgage rates fuelled a homebuying boom in Canada, which led to higher housing costs. Commodity prices have also risen sharply, particularly after Russia’s invasion of Ukraine. And supply issues are inextricably tied to public-health measures in other countries, such as recent shutdowns of major cities in China.
Domestic stimulus is another factor, the Fed researchers said. Canada’s fiscal response to the pandemic amounted to roughly 20 per cent of GDP, based on International Monetary Fund estimates from last fall. Government transfers to households spiked in 2020, driving up disposable income and supporting consumption. By June of that year, retail sales in Canada were running above prepandemic levels, despite huge job losses.
Inflation can also be self-fulfilling. For instance, companies may raise prices in anticipation of higher costs.
“I really think that the Bank of Canada is going to have to see a lot of things go right that are outside of its control to return inflation to target without causing a recession,” Mr. Mendes said. Those include an easing of supply chain troubles, lower energy prices and the U.S. economy cooling to a more sustainable position, he said.
“It’s an extremely tough spot for them to be in.”
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Matt Lundy