The Bank of Canada (BOC) may face significant obstacles attempting to reduce inflation back down to its goal of 2%, warned Nicolas Vincent, an official for the central bank during his speech in Montreal on Wednesday.
It was the first speech given by Vincent since he became an external non-executive deputy governor for the BOC, who also works as a professor of economics at HEC Montréal.
During the Covid-19 pandemic, many Canadians managed to save money, with the savings rate hitting a high of 26.5% in the second quarter of 2020, a high which is still making its slow descent.
The labour market also remained strong and the combination of those two factors has led to imbalances in the supply and demand chain.
“A robust labour market and savings accumulated during the pandemic have supported strong consumption,” said Vincent. “This has created what economists call a state of excess demand — a situation where demand runs ahead of supply— thereby driving up prices and wages.”
The Bank of Canada also cited the rising cost of energy prices, which remain out of their control and are often set by global markets. The price of gas has increased by 0.8% year-over-year in August after dropping 12.9% year-over-year in July, according to the Financial Post.
These fluctuations played a major role in headline inflation’s rise to 4%.
The higher cost of gas raises the overall cost of goods, which are then passed on to the consumer, increasing inflation evermore.
Vincent said it wasn’t just consumers who changed their spending behaviour during the pandemic, but also companies and retailers began raising prices with a greater frequency than economists had previously observed.
“Price increases were larger than normal during this period, driven by the higher costs that firms were facing and helped along by strong demand. Firms also raised prices more frequently than usual,” said Vincent. “We believe that this behaviour by firms — both here and abroad — is intimately linked to the stronger-than-expected inflation we’ve seen.”
This has become a tit-for-tat game between firms as they gauge if their competitors will be able to secure the appropriate supply to meet their demands.
If they suspect their competitors will be unable to match the supply, they increase their prices to secure the flow of goods. In the end, the consumers will pay the ultimate price.
Vincent said the biggest problem with this practice is that it’s likely to become a self-fulfilling prophecy, which continues to drive up inflation in the near-term as shoppers will attempt to buy now to avoid higher prices in the future, creating a “feedback loop.”
“Perhaps the biggest risk of all is the idea that recent pricing behaviour could become self-perpetuating. If you continue to expect your suppliers and competitors to make frequent price changes, you might be more prone to do the same yourself, creating a feedback loop,” said Vincent.
“Under certain conditions, this could make prices even more sensitive to shocks. In other words, if recent pricing behaviour settles into a new normal, it could complicate our return to low, stable and predictable inflation.”
