Francois Villeroy de Galhau, governor of the Bank of France, Ignazio Visco, governor of the Bank of Italy, Christine Lagarde, president of the European Central Bank, and Tiff Macklem, governor of the Bank of Canada, prior to the central bank session of the Group of Seven finance ministers and central bank governors meeting in Niigata, Japan, on May 13.POOL/Reuters
John Rapley is a political economist at the University of Cambridge and managing director of Seaford Macro.
Canada’s recent experience with inflation mirrors those of other developed economies. After falling for several months, it recently plateaued, with core inflation even ticking back up in places. Those who read me regularly will know that I’ve been predicting that for a while now and even though the Bank of Canada insists we will eventually return to 2 per cent inflation, I remain doubtful.
Like all central banks, the Bank of Canada has been too confident in its abilities and is now struggling to account for the persistence of inflation and the resilience of the economy despite its sharpest monetary tightening in decades.
It’s not like the bank hasn’t done everything by the book. The conventional theory of inflation attributes it to excess money supply creating a surge in demand, with the principal channel coming through the labour market: high employment and healthy wages means workers spend, keeping the economy hot. So by raising interest rates, central banks can discourage people from spending and encourage them to save or pay off their debts, thereby tamping demand. That’s what the banks have done, yet here we still are.
Faced with this conundrum, central banks have taken to blaming fiscal policies that are still too loose and the excess savings that were built up during the pandemic. Governments, they say, have been just too generous. But the evidence that excess savings and stimulus are driving inflation is actually rather thin.
What is undeniable, though, is that employment and wage growth remain healthy, while labour productivity is falling. With employers having to pay more to workers who produce less, labour costs are rising even faster than the wage bill. Employers are then passing those increased costs onto consumers by raising their prices. Ordinarily, that might drive away customers. However, because real wages are modestly positive, with average wage increases now outstripping inflation, working people are able to absorb price rises.
That cycle, which is vicious for central banks, currently prevails across Western countries. Central banks have thus concluded that they will just have to keep at it, and keep interest rates higher for longer than they’d planned. Sooner or later, say most economists, unemployment will have to rise in response. Only then will the battle against inflation be decisively won. However, the labour market may not be the principal channel through which monetary policy does its work this time.
True, we are starting to see less turnover in job markets. There’s less job-switching by people hunting for better offers, and that’s easing the upward pressure on wages, with workers settling in for the economic storm they keep hearing is coming. Nevertheless, we’re seeing few signs of imminent layoffs, while the unemployment we have seen has tended to be concentrated in a small number of high-wage subsectors, such as finance and tech.
In the rest of the economy, it appears employers are holding their people close. That may continue. With workers hard to find, many bosses may opt to retain their work forces through the sort of short, shallow recession most economists are expecting, since the costs of re-hiring and retraining workers may exceed the short-term savings they make by cutting their payrolls.
It may therefore be only in asset markets that we see the steam come out of inflation. For investors whose incomes and borrowing have depended on rising or at least steady house prices, stresses may emerge, especially for those holding variable-rate mortgages. That may force some liquidation, which should keep a lid on the runaway inflation we’ve seen in real estate. Equally, any companies still paying their underemployed workers amid a sales slump will have little choice but to cut their margins. That will further depress stock prices.
Add it all up, however, and you have wages holding up even as asset prices and corporate earnings are falling. So, although employed homeowners may have to tighten their belts somewhat, they should be able to absorb their rising mortgage costs, thanks to their nominal pay rises. And even if people do not like higher prices, at least for now, they’re paying them, and so firms do not have to slash profit margins too deeply. We aren’t going back to 2 per cent inflation any time soon, no matter what the central banks do.