U of T economist unpacks soaring inflation – and how Canadians can cope

(Photo by Zou Zheng/Xinhua via Getty Images)

With inflation at its highest level in decades, are storm clouds gathering on Canada’s economic horizon?

Inflation hit 8.1 per cent year over year in June, eating away at Canadians’ savings amid rising prices for everything from gas to groceries.

The following month, the Bank of Canada responded by hiking its benchmark lending rate by a full percentage point, the largest such increase in more than two decades – and more tightening is likely on the way. Rising rates, in turn, have implications for anyone who borrows money, including businesses, consumers and homeowners. In one ominous sign for the tech sector, Ottawa-based Shopify cut 1,000 jobs, equal to 10 per cent of its workforce, last week.

Yet, despite some predictions that Canada is hurtling toward a painful recession, University of Toronto economist Peter Dungan remains optimistic that sunnier days are ahead. In his research, he uses computer simulations to forecast the short- and long-term trajectory of Canada and Ontario’s economies.

“If we have a recession, it will be from a state at which the economy actually is in very good shape in terms of low unemployment and a high level of output,” says Dungan, an associate professor emeritus of economic analysis and policy at the Rotman School of Management who is cross-appointed to the department of economics in the Faculty of Arts & Science and the Munk School of Global Affairs & Public Policy

U of T News recently spoke with Dungan about the state of the Canadian economy, where it’s headed, and how households and students can cope with sky-high inflation.

Peter Dungan (photo by Rick Madonick/Toronto Star via Getty Images)

What, exactly, is inflation?

Inflation is a change in the average price level. Inflation can be temporary in the sense that if the price level goes up, but then doesn’t keep rising, then inflation goes up and comes back down.

We’ve seen a significant change in the price level for a number of key items recently: oil, gas, wheat, stuff like that. But if the prices of things don’t keep rising – even if they stay where they are – the inflation rate goes back down again. It’s only if prices keep rising faster than they have before that you get a rise in the inflation rate.

Why would that happen? It could be the world keeps throwing disasters at us. The other big danger is people expect inflation to rise, so they keep bidding up their wages and demands, and that gets built into higher prices and then you’re into a “wage-price spiral,” as they call it. That second scenario isn’t happening yet. That’s not what's causing our inflation so far – and, so far, the evidence seems to be that expectations in the longer term are not rising significantly.

How did we get here?

There’s no easy answer.

In a way, if you allow an economist to use demand and supply, like we always do, this is a supply-side shock. This is something coming from weakness of supply, or a shortage of something. There was a certain amount of that having to do with microchips, and all kinds of other key ingredients that were being held up at ports or in China because of COVID-19 lockdowns there. To some extent, that’s still happening.

But it’s also fairly clear – at least in some countries – there’s what is called “demand pull” going on as well. Coming out of the [pandemic-induced] recession, people have started to buy things again – goods and services. The economy was in fairly good shape before we went in and it was well supported – as it had to be, at least in Canada and the U.S. – when we were in the pandemic, but that’s left people with a lot of money to spend as we once again emerge.

When you have a relatively large number of people pursuing a limited supply of goods, that tends to cause prices to increase. So, we have a mixture of “cost-push” and “demand-pull” inflation going on at the same time in varying degrees in different countries.

For example, there’s a bit more demand pull going on in the U.S. than in Canada because they had somewhat more expansionary fiscal policies more recently because they were worried about Omicron. On the other hand, in Europe – where there’s also significant inflation – it’s less about demand pull and more of a supply problem related to oil and natural gas due to the war in Ukraine.

Unfortunately, there’s no simple answer.

Why are some experts predicting a recession at the same time as we are experiencing record-low unemployment?

One of the things to distinguish is level versus change. A recession, technically speaking, is a change in the state of your economy. If it doesn't grow at its usual amount – especially if it contracts – then we call it a recession. But the state of the economy could be very high or very low when the change occurs.

As it happens, if we have a recession, it will be from a state at which the economy is actually in very good shape in terms of low unemployment and a high level of output. That would be much less serious than a recession that occurred when the economy was already weak because we hadn’t recovered from a previous recession, or there were other problems affecting the economy.

By the way, a recession can be -0.1 per cent growth or it can be minus five per cent. And there’s a huge difference between those two. It’s only indicative of the direction the economy is heading as opposed to the scale.

A lot of people who are talking about a recession – not all, but some – are only talking about something that would be much milder than either the one induced by the pandemic or the recession that’s sometimes called the Great Recession that started in 2008-2009.

There are some people who are ringing alarm bells, saying it’s going to be a bad recession. I do not happen to agree with them myself. But there’s all kinds of possibilities out there and it depends on what happens in the geopolitical realm, too.

What’s the economic forecast for Canada?

On the inflation front, I am very confident that we will eventually get back to two per cent. It’s the Bank of Canada’s target, they have the tools to be able to achieve it, and they seem to be determined to do it. The thing is, it will take longer than we thought because there was more of this “cost-push inflation.” Before the Ukraine war broke out, nobody saw that coming: the huge increase in oil, gas and food prices occurring as a result. That’s just a nasty surprise.

How much damage has to occur to the economy to get back to two per cent? That’s a more open question. If, in effect, there’s no more supply shocks and the Bank of Canada’s and other central banks’ rate hikes cool demand, then we may be able to that low inflation rate in two or three years with relatively modest losses in employment and GDP.

On the other hand, if shocks to the supply side of the economy keep coming at us, we’re in different territory. Then you really need to push on the demand side to weaken inflation. The big question in the backs of central bankers’ minds, is: Is high inflation getting into people’s expectations of the future and their wage and price bargaining? Once that happens, then you’re in the nasty world of the late 70s and early 80s. Those decades required a huge recession to literally bleed the inflation out of the system. And nobody wants to go there.

Many Canadians haven’t experienced high inflation, but you were in university during the hyperinflationary 1970s. How did that compare to now?

The similarity, though it’s extremely limited, is that we’re temporarily getting back to rates of inflation we haven’t seen since that period. So, yes, that was a time in which inflation was like eight, nine, 10 per cent per year for a number of years. But I don’t think that’s going to happen this time around.

There’s a big difference, too. Nowadays, central banks have clear inflation targets and are determined to hit them. That’s a policy goal that only began in the 1990s, partly in reaction to the failures from before.

Unless there's an absolute, major change in the way our central banks operate or are allowed to operate – which I consider highly unlikely for North America, Europe, Japan, Australia and New Zealand – we’re going back to low inflation.

The other major difference between then and now is that, in those days, because central banks didn’t have a target for inflation, and because inflation was all over the map for a significant period, people’s expectations were, in a sense, unanchored. When unions went into wage bargaining, they didn’t know what inflation was going to be – only that it was likely to be high. So, of course, they bargained for a big wage increase. That gets passed through into other prices, which then validates the inflation and then: “Oh my God. We’re in trouble.”

Today, so far as we can tell, people expect inflation to be high for a year or two, but the expectation for the longer term doesn’t seem to be moving yet. People still trust that this is temporary. If that that changes, then it’s a new world – or maybe I should say old world. We’re back to the 70s and 80s again. And it would take higher levels of unemployment and more significant recessions to get inflation down and convince people to drop thier expectations. But we aren’t seeing it yet.

What tools do countries have to rein in inflation?

Largely, the job falls on the central bank. It uses higher interest rates to slow down particular parts of economic activity like housing and purchasing cars and things like that. That’s your first line of defence.

If it wanted to help, a federal or provincial government could also raise taxes or cut spending, but it’s very politically difficult to do that – and it’s not clear at this point that it’s necessary. It’s not that serious a problem. Some provincial governments are actually throwing money at people. I don’t mind that if it’s going to people who are more affected by inflation, including those living on fixed incomes, low-income people and others who are suffering. But you don’t want across-the-board tax cuts or spending programs to boost the economy. The economy is boosted already. The unemployment rate is at historic lows. We don’t need boosting. If anything, we need to un-boost.

What do you make of the news that Shopify laid off 10 per cent of its staff?

Shopify’s problem was that they took a real boost during the pandemic because, of course, there was more online shopping. What we didn’t know coming out of the pandemic – regardless of whether there was going to be recession and inflation-fighting – was whether people were going to go back to brick-and-mortar stores or continue shopping online. It looks like Shopify was excessively optimistic about how much online would occur. So, they’re cutting back. I have a feeling that would have happened anyway.

What can the average person and household do to protect themselves from inflation? What about students?

There’s no magic wand on this one. It’s possible some prices will come down in the future, in which case it’s much less of a problem. But to the extent that some things cost more because of ongoing problems in Europe – if the Ukraine war is going to continue, isolating Russia as a major supplier of oil, gas and wheat – what this means is that the world is not going to be quite as generous as it was before to a student or household. Some things are just going to be more expensive, including food items and fuel. It may not keep getting worse, but it may not get back to the way it was a year ago either.

That pain has to be recognized. It’s a cost that has to be borne. The world is not making wheat available for us to buy burger buns and oil – and then to move the burger buns around between restaurants – as generously as it was before, so there’s going to be a hit.

What that means is you’ll have to review your budget. Review what’s important to you and make changes to move away from the more expensive things and toward the less expensive things –realize that the budget is tighter than it was before. There’s really no way around it.

Again, I’ll hold out the small hope that there will be some adjustment on the supply-side effects as time goes by, so that we may be able to see perhaps even lower rates of inflation than two per cent in times to come. Certain things that we really like might get cheaper again. That’s definitely a possibility, but it depends on how the world evolves.






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