The nebulous outlook for inflation as the economy reopens

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One of the most perplexing questions for the Bank of Canada that will emerge from the current crisis is also one of the most important ones for our inflation-targeting central bank. It’s near-impossible for the bank – or anyone else – to say whether the aftershocks from this bizarre global economic event will be inflationary or deflationary.

In its quarterly monetary policy report last week, the bank elected not to publish economic forecasts in light of the profound uncertainties surrounding the COVID-19 impact – and that included no projection on inflation. That’s a pretty big omission for a central bank that has spent the past quarter-century using a 2-per-cent inflation target as the unshakable anchor of its monetary policy. Everything the bank does with interest rates is guided by the overriding goal of getting inflation to that target (or very near to it), and keeping it there.

But the bank explained in the report that it simply can’t say where inflation will go once the economic lights are switched back on.

“[Inflation] is the toughest part of all in this environment to make a forecast around,” Bank of Canada Governor Stephen Poloz said in a press conference last week. “This is almost impossible for us to glean out.”

What we’re witnessing here is an extraordinary real-world experiment in the most elemental forces of economics: supply and demand.

Both have been, to a large extent, shut off. Suppliers – restaurants, contractors, manufacturers, etc. – have closed for business. “Demanders” – more commonly known as consumers – are staying home rather than going out and consuming.

After Wednesday’s consumer price index report from Statistics Canada, we have a pretty clear picture where inflation is going as long as the economy is still in lockdown mode. The annual rate plunged to 0.9 per cent from 2.2 per cent in February; many economists think it will dip into negative territory before we’re done. The biggest factor in that inflation drop – gasoline – is a vivid illustration of a sector where demand has been reduced much, much faster than supply.

But what we can’t possibly gauge is how each side of the supply-demand equation will come back once COVID-19 restrictions are eased. Which means we can’t be sure whether to worry about inflation undershooting its target or lurching well above comfortable levels when the taps are reopened.

One possibility is that a huge amount of pent-up demand will be unleashed, as consumers look to catch up on shopping, socializing and tourism. Yet supply of both goods and services might still be restricted – fewer tables in restaurants, fewer seats on aircraft, for example. Global supply chains for manufactured goods may remain disrupted, as different countries return to normal at different paces, and cross-border trade may face continued health-related slowdowns. If the return of production is slower than the rebound in demand, the result would be significant inflationary pressures.

But the recovery could well unfold in the opposite direction. Barriers may be lifted to output, but consumers – whose finances were seriously damaged by the shutdowns, and whose collective psyche about public interactions has been shaken – may be slow to return to normal levels of consumption. If production returns ahead of consumption, the economy will be oversupplied, resulting in downward pressure on inflation.

For now, the bank believes the bigger risk to inflation is to the downside – which, in absence of a crystal ball, is the prudent direction to lean anyway.

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As Mr. Poloz said last week, deflation – the actual sustained decline of consumer prices – is an extremely serious condition, one that can decimate economic growth and bring debt excesses to a head. Even weak inflation over an extended period could erode consumers’ inflation expectations, which would make it hard for the central bank to use interest rates to steer the economy on the desired path. So if the country was going to miss the bank’s inflation target, it would be better to do so on the too-much side (within reason) than on the too-little side.

That’s part of the logic behind the bank’s barrage of policy measures in the past month, which has injected $200-billion into the financial system. That massive expansion of its balance sheet is, unquestionably, a serious inflationary force. The bank’s first order of business is to lean heavily against the risk of a disastrous deflationary slide.

As Mr. Poloz pointed out, much of the central bank’s balance sheet expansion to date has been short term – it has bought debt that matures in a year or less, and thus will fall off its books in a year or less. This aligns the strategy with what the central bank expects will be a relatively short-term crisis; as the need for such measures eases, the assets will expire and the balance sheet will unwind. This should dampen the inflationary aspects before they become problematic.

Perhaps he should add “fingers crossed” when he says that. Policy makers in this country have never thrown so much stimulus at the economy so quickly. And it’s all aimed at an economic shock that, by its nature, could whipsaw both faster and on a grander scale than anything we’ve ever seen before. The central bank could be playing soft-toss with nitroglycerin.

Still, among all the risks that the central bank faces, inflation is the one Mr. Poloz would almost welcome. The Bank of Canada has decades of experience using interest rates to rein in inflation.

“That would be a nice problem to have, to be frank,” he told the House of Commons finance committee last week. “Because that is the one that we know the best how to deal with.”

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