What's causing inflation? Bottlenecks or too much money?

 

Whether the recent increases in Canada’s consumer price index are temporary changes due to supply and labour shortages in some sectors or a more permanent problem driven by the excess creation of money is being hotly debated by economists at the moment.

The first explanation is favoured by economists at the Bank of Canada and some academics. They argue that September’s 4.4 per cent increase in the CPI was caused mostly by supply-chain bottlenecks that will soon end, allowing a prompt return to the targeted two per cent rate of inflation. They buttress their arguments by drawing on data showing that just three items — energy, food and housing — explain most of the increase in the index.

The second explanation is favoured by economists who have studied the history of inflations using the monetarist model popularized by 1976 Nobel Prize-winner Milton Friedman, who in a classic study of the monetary history of the United States found that “inflation is always and everywhere a monetary phenomenon.” These economists argue that the Bank of Canada has increased the money supply by an amount that in the light of experience is likely to lead to substantial inflation.

Which of the two views is right could not be more important for policy. If the price rises are temporary, there is no need for higher interest rates and tight fiscal policy. But if the monetarists are correct, the inflation will continue and even increase, requiring tighter monetary and fiscal policies — the more so the longer the excessively large money supply is allowed to persist. The corrective policies will involve recession and unemployment and require reductions in government spending — all of unforeseeable depth and duration.

So which is it? A recent paper by John Greenwood, former chief economist at Invesco, one of the world’s largest investment management companies, suggests the monetarist argument has some explanatory power. The nearby graph is from his paper, with Canadian data added.

It shows the percentage increase in each country’s consumer prices between December 2019, before COVID, and August of this year, paired with the percentage increase in its national M2 between December 2019 and July 2021. M2 is the most widely used indicator of the supply of money and a key determinant of national monetary conditions. The monetarist theory predicts that, all else equal, the greater the increase in the money supply, the greater future price increases will be.

The dots in the graph show that for the sample of the five countries there is a strong, positive relationship between the growth in M2 and inflation. The U.S. has both the highest inflation and the highest M2 creation. Canada has the second-highest values of both, followed by the United Kingdom and at much lower levels, Switzerland, and Japan.

The positive relationship between money supply growth and inflation supports the view that inflation in Canada can be expected to continue and will likely accelerate if future fiscal deficits continue to be financed by additions to M2.

Does the graph provide any insight into the monetary conditions vs. temporary bottlenecks debate? If supply chain disruptions are the problem, then Switzerland and Japan should be affected in the same way as the other countries. But that’s clearly not the case. Inflation is essentially non-existent in Switzerland and Japan.

A danger in Canada’s current situation is that although supply chain bottlenecks and labour shortages may be temporary, some businesses have dealt with them by raising output prices to cover higher input costs. At the same time, many businesses have had to raise wages to attract workers in scarce supply. If people build these price and wage increases into their inflation expectations, inflation may persist even after the shortages of supplies and labour have been cleared.

The cost of supplies may or may not return to pre-crisis levels, but at least some of the higher output prices may remain. And workers will strongly resist any attempt by employers to reduce wages back to pre-pandemic levels. Unions are likely to demand wage parity for their members and set a new standard for workers in the non-unionized sector of the labour market. The wage-price spiral that dominated the 1970s may return.

Its clear relation to the money supply suggests inflation will become an increasingly serious problem for the economy and that the Bank of Canada and federal government will soon have to make some difficult decisions. Eventually there will have to be a reckoning as to whether the excessive government spending that fuelled the inflation was caused by an ideologically driven expansion of the role of government in society or by the problems brought on by the COVID pandemic.