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Why inflation isn’t really a problem

by SuperiorInvest

Central banks may soon control inflation, but at what cost?

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Most readers are already offended after reading the title. Let me explain.

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Clearly, inflation is a huge problem for households, businesses, government budgets – and of course for monetary policymakers. Arthur Okunhe is famous poverty index it has only two elements and inflation is one of them. In addition, inflation is likely to be worst at the start when prices outpace incomes, biting into real purchasing power – the gap in the second quarter between CPI inflation and the rate of hourly wage growth reached four percent, meaning households are poorer.

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With an average increase in input costs of around 10 percent and recent bottom lines, businesses are biting more than they can chew. Even worse, it was a beast that was thought to be long dead and now it has been resurrected and is wreaking havoc. If that really isn’t a problem, then what is?

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First and foremost, central banks will win the battle. Although it’s been decades since they last conquered the beast, their playbook is well-rehearsed and has proven itself in various business cycles over the past few decades. Central bankers have the tools to continue tightening, not only until inflation itself is subdued, but more significantly until inflationary expectations are completely subdued. If so, today’s inflation is temporary, and the only real debate is how temporary.

But that is the key to the problem. Inflation could soon be contained, but at what cost? Economies everywhere will react negatively, and indeed are already showing signs of it recession or at least slowing down. That’s a scary prospect, given that it can take up to 18 months for a change in interest rates to affect the real economy; given the timing of the increases so far, there is much more weakness in the stock. It will not hit every economy equally. Fortunately, most of the world’s “powerhouse” economies have ample evidence of pent-up spending pressure. Rate increases in these happy zones actually encourage growth.

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Canada has some retained earnings in reserve, but our runway is much shorter. Here, housing markets have been in the red for years, the debt-to-income ratio is sky-high, and the average household’s wealth is heavily dependent on the value of their primary residence. Add to that the greater’s immediate debt sensitivity variable mortgage cohort, the shock to those who choose to lock in a higher rate and the ultimate impact of the rate change when current mortgage contracts expire. Given this situation, at least 60 to 70 percent of our gross domestic product is highly sensitive to rate hikes.

It becomes darker. A soft landing is as tricky as it gets. More specifically, monetary authorities have been known to overdo it. We can hardly blame them; monetary policy is a blunt instrument at best, and perfect results usually require a lot of luck. Moreover, breaking the psychology of inflation almost dictates a monetary overshoot, especially after a protracted phase of decent price behavior.

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Math is also a problem. Most cited, current inflation numbers they are actually quite outdated and the inflation correction may actually be long before consumers or businesses realize it. That’s because we’re using this month’s prices compared to prices from a whole year ago. We tend to do it this way for good reasons: the numbers are easy to grasp and useful for compensating adjustments and a whole host of other pricing decisions. The problem is that monthly price action can be in line with targets – or even below target – long before it hits the headlines. In fact, it can take a full 12 months to clear up – and by then it’s almost always too late for the economy.

Take 1991. Amid monetary tightening, the new year brought the GST, which added seven percent to the cost of most goods and services. Not surprisingly, the consumer price index immediately jumped to 6.9 percent. Fearing a rekindling of higher price expectations, the central bank went to work. By the end of the year, year-on-year increases in the consumer price index decreased to 3.8 percent, and the growth of core prices amounted to only 2.9 percent.

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Success, right? Poorly. When 1992 came around, the GST was fully incorporated – meaning the year-on-year change disappeared. In monthly terms, prices fell. In January 1991, annual price growth was down to 1.8 percent, and by mid-year inflation for all items was only 1.1 percent. Suddenly, concerns shifted to possible disinflation, or worse, deflation.

While the new national sales tax isn’t a concern this time around, the dynamic is still the same. It’s not wearing much, but on a monthly basis core price growth is slowing rapidly, from double-digit levels in May to around four percent in October. Considering we are only in the ninth month of tightening, this is a remarkable shift. Allow time for the effects to take full effect and we could be back to 1992.

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Ah, but then we survived. Won’t it be the same this time? Not necessarily. Disinflation and deflation are much more complicated beasts; The central bank’s handbook is much less clear on these than on inflation. Just ask Japan, where disinflation and deflation are decades-long mysteries. Human behavior causes deflation to persist – if prices are lower tomorrow, why buy today? Or for that matter, why buy at all if you just don’t have to? In this way, deflation begets deflation.

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Can we escape the deflationary trap? This largely depends on the state of the underlying demand. If the economy is truly overstretched, consumers may put off purchases much longer than usual, contributing to the malaise. Businesses dependent on domestic demand will feel the pinch. If there is a glimmer of hope, it is probably in exports. Stronger fundamentals in the United States and elsewhere suggest external markets will be more resilient.

After all, inflation is not the main problem. It is the response to the drug that will tell the story. This response will not be the same across countries – but Canada’s weak fundamentals suggest a more acute response here.

Peter Hall is the CEO of Econosphere Inc. and former Chief Economist of Export Development Canada.



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