Quantitative Easing

These Three Common Inflation Myths Don’t Describe What’s Happening Right Now

Chances are that at least some of what you think you know about inflation is wrong.

The same is true for all of us. Even supposed experts do not claim perfect foresight when it comes to forecasting or managing inflation.

Former Federal Reserve Governor Daniel Tarullo said the Fed doesn’t have a theory of inflation. Prominent economists such as Jon Steinsson of the University of California at Berkeley acknowledge “our very flawed understanding of inflation”.

But that doesn’t mean that no story is happening. In corresponding with readers, I am struck by how often three notions are either flatly wrong or not quite right. These three myths taint much of the conversation surrounding the current inflation explosion. It may be useful to look at each of them in turn.

They are greedy workers: A notion that keeps cropping up in readers’ emails is the belief that inflation is the direct result of workers’ outrageous wage demands. The push for a minimum wage of $15 an hour is seen by many as one of the main reasons for soaring prices.

It just doesn’t fit the facts. Wages are increasing by about 4% per year in Canada. In comparison, inflation is 7.7%.

In both Canada and the United States, wage increases are lagging significantly behind inflation. Workers haven’t taken a bigger slice of the pie in recent months. On the contrary, they have fallen behind. It is therefore extremely difficult to attribute the inflationary surge of the last year and a half to galloping wage demands.

Certainly, this image could change in the months to come. It is reasonable to expect that workers will try to make up for their lost purchasing power by renegotiating wages and pushing for higher wages. So far, however, real wages have fallen victim to rising prices, not their main driver.

It’s about broken supply chains: Another common notion is that inflation reflects the innate fragility of global supply chains that have collapsed during the pandemic.

There’s some truth to that, but not in the way most people think. Supply chains have actually managed to deliver huge amounts of foreign goods during the pandemic. Contrary to what many people think, imports of goods into Canada and the United States have not declined over the past two years. They have reached new heights.

It is therefore difficult to blame faulty supply chains for inflation. A more plausible description of recent events is that demand has reached unprecedented levels and exceeded the ability of supply chains to keep up.

This is about printing money: Another common misconception is that the central banks of Canada and the United States simply “printed money” to keep governments afloat during the pandemic and thus fueled inflation. It’s stretching the truth.

The quantitative easing programs run by the Bank of Canada and the US Federal Reserve essentially consisted of central banks buying government bonds on the open market from commercial banks. Central banks paid for them using a special type of central bank money called reserves or settlement balances.

Reserves cannot be used by commercial banks to provide loans to consumers or businesses. They can only be used to settle obligations between banks. As a result, their ability to stimulate inflation is severely limited.

Bonds bought by central banks have not disappeared. Governments still had to pay them back. But the large-scale purchases of these bonds changed the composition of what commercial banks owned. They used to hold bonds; now they held assets at the central bank – assets that could only be used under certain rather limited conditions.

Why was all this important? Among other things, bond purchases by central banks served to drive up bond prices and thus drive down bond yields, i.e. the rate of interest they paid bondholders. obligations. (Bond yields move in the opposite direction to bond prices.) This kept long-term interest rates lower than they otherwise would have been and encouraged more lending and buying.

You can argue that lower rates can help fuel inflation, and you’re probably right. Lower rates, however, are desirable when economies face a downturn caused by big stresses like a pandemic. And the buying of bonds that pushes rates down is ultimately reversed, either by the maturing of the bonds or by the central bank selling the bonds.

All of this is admittedly an obscure process. But that’s not what most people think of when they hear “printing money.” History shows that it is not necessarily inflationary either. The Bank of Japan has practiced quantitative easing for years without a major surge in inflation. The Federal Reserve did the same ten years ago.

So if all of these theories fail, what is a more correct explanation for today’s runaway inflation?

The strongest story seems to be that it started when North American governments provided too much stimulus during the pandemic. This triggered a huge wave of unexpected demand.

Exceptionally, demand focused on commodities. This appears to have happened because people were locked down and many service businesses were shut down. Prices for goods soared as people shunned travel and restaurants and instead turned to buying new gadgets or home renovations.

It then appears that the resulting inflation has increased, probably due to the tensions that accompanied the reopening of the economies. Inflation then spiked when Russia invaded Ukraine, pushing food and oil prices to new highs.

Admittedly, this is a messy multi-part explanation. It will almost certainly turn out to be wrong in some respects. But at least it matches what we can say with reasonable confidence, contrary to some theories.

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