Shoppers at the Toronto Eaton Center on July 18. Fred Lum/The Globe and Mail
Analyzing the causes of high inflation in Canada, many experts point to interest rates that have been too low for too long, along with rising commodity prices.
But Canadians might consider another culprit: their neighbors to the south.
In a recent working paper, three US Federal Reserve researchers analyze the role of fiscal stimulus in today’s inflation shock. They note that the “generous” response to the pandemic, especially by the US government, led to an increase in demand for goods that was not matched by supply – and eventually spread to other countries.
For Canada, the side effects were significant. Annual inflation in February, 5.7 percent, was about four percentage points higher than in recent history. Of that “excess inflation,” U.S. fiscal stimulus contributed about 2.3 percentage points, Fed researchers estimated, noting that the impact was much greater in Canada than elsewhere.
“Canada, a country with strong trade ties to the US, is characterized by a high level of hyperinflation associated with exposure to foreign fiscal stimulus,” they wrote.
The consumer price boom is only getting worse. Canadian inflation hit 7.7 percent in May, the highest in nearly four decades. Bay Street analysts expect it to be even higher when June data is released on Wednesday. Inflation in the US reached 9.1% in June.
Central bankers are now trying to tame inflation at the fastest rate of monetary tightening in decades, notably through a series of interest rate hikes. The Bank of Canada raised its key interest rate to 2.5 percent from 0.25 percent in less than five months, and bank officials have signaled that more increases are on the way.
“There is obviously a large component of Canadian inflation that is driven by the overheated nature of the U.S. economy,” Royce Mendes, head of macro strategy at Desjardins Securities, said in an interview. “The fiscal response has been huge, but the delay in tapering off monetary stimulus has also played a big factor in that.”
Like other countries, the US moved quickly to launch programs to support the pandemic and reduce the financial impact on households. Government spending played a “positive role” during the crisis, Fed researchers wrote, supporting a strong economic recovery and likely preventing “worse outcomes.”
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The US response was particularly large. It has spent more than US$5 trillion, or roughly 25 percent of gross domestic product—proportionally more than most countries.
US stimulus was often paid directly to households. Families can receive three rounds of checks – regardless of whether their employment has been affected by the pandemic. A person with an annual income of less than US$75,000 can receive US$3,200.
Loaded with cash, Americans began loading up on goods, in part because they had fewer options to spend that extra cash on services. A speculative frenzy swept across asset classes, from stocks to sneakers.
At the same time, businesses couldn’t keep up with demand, with factories and ports often shut down by public health measures, leading to supply chain problems that pushed up prices.
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The Bank of Canada has consistently underestimated the threat of inflation and said about a fifth of the error in its forecast was related to global supply chain pressures, including the extent to which people are buying goods.
“Instead of weakening as in past downturns, U.S. consumer demand for goods unexpectedly jumped well above pre-pandemic levels. Supported by fiscal policy measures, US household incomes came in higher than expected,” the bank said in its monetary policy report on Wednesday.
“Overall, strong foreign demand for tradable goods such as appliances and furniture pushed up prices globally, including for Canadian consumers.”
Fed researchers outlined three ways fiscal stimulus affects prices. Canadians are paying more for American goods as American companies struggle to keep up with hot demand. Likewise, Canadians pay more for products from countries outside the US that have seen a boost in US demand. Finally, Americans are ordering more Canadian goods than usual, contributing to the supply-demand imbalance seen at home.
“When we’re competing for goods or some services on the world stage, and we’re competing with an extremely strong American economy, we’re going to have to pay to get our fair share of those goods and services,” Mr. Mendes said.
There are, of course, many explanations for the spike in inflation. Low mortgage rates have fueled Canada’s home buying boom, leading to higher housing costs. Commodity prices also rose sharply, especially after Russia’s invasion of Ukraine. And supply issues are inextricably linked to public health measures in other countries, such as the recent lockdown of major cities in China.
Domestic incentives are another factor, Fed researchers said. Canada’s fiscal response to the pandemic amounts to roughly 20 percent of GDP, based on International Monetary Fund estimates from last fall. Government transfers to households increased sharply in 2020, boosting disposable income and supporting consumption. By June of that year, Canadian retail sales exceeded pre-pandemic levels, despite massive job losses.
Inflation can also be self-fulfilling. For example, companies may raise prices in anticipation of higher costs.
“I really think the Bank of Canada is going to have to get a lot of things right that are out of its control to get inflation back on target without causing a recession,” Mr. Mendes said. These include easing supply chain problems, lower energy prices and cooling the US economy to a more sustainable position, he said.
“It’s an extremely difficult place for them to be.”
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