Economic insight provided by Alberta Central Chief Economist Charles St-Arnaud
Main takeaways
- The COVID recession is not a typical recession. Instead, it needs to be analyzed as a natural disaster. However, the difference is the scale of the disruption (global vs regional) and the duration (years vs weeks).
- Most of the shocks holding back the economy are supply shocks. While demand has recovered, it remains below where it was at the onset of the pandemic.
- Demand shocks and supply shocks and the policy response needed to address the increase in inflationary pressure are very different.
- In the case of supply-induced inflationary pressures, the central bank needs to hike rates to slow the demand side of the economy, reducing economic activity and employment, all else equal.
- This situation creates a dilemma for central bankers: cooling inflation at the expense of employment or tolerating higher inflation to allow further recovery in the labour market.
- The central banks’ mandate will ultimately dictate how they respond. Those with explicit full employment mandates, such as the U.S. Federal Reserve, are likely to be more patient than central banks that have been directed to focus solely on price stability, such as the Bank of England and the European Central Bank. Central banks with flexible inflation mandates such as the Reserve Bank of Australia are also more likely to be willing to allow a rise in inflation and be less aggressive to fight inflationary pressures.
- In the case of the Bank of Canada, while explicitly aiming at controlling inflation, it has shown some degree of flexibility in the past.
- The Bank of Canada should use its flexibility to support the recovery as long as possible and lower the amount of slack in the labour market. However, if inflation expectations become unmoored, the central bank would have to respond; however, this will be at the expense of a slower recovery and higher unemployment.
As the recovery from the recession, induced by the COVID-19 pandemic, takes hold, the global economy is facing a multitude of supply disruptions, leading to an increase in global inflation. In many cases, such as in in the US, EU, UK and Canada, inflation has not been this high in over a decade. The situation has raised the spectre of another inflationary period similar to the 1970s. In this report, we look at what distinguishes supply shocks from demand shocks, what makes supply shocks more challenging to an economy, and the implications for monetary policy.
It’s about supply, not demand
The COVID-19 recession was not a normal recession and needs to be viewed as such. Instead, the economic impact of the pandemic needs to be analyzed and viewed as a natural disaster, not as a traditional demand shock. For example, when a flood affects a region, economic activity drops because of both a reduction in production and consumption. Once the water recedes, economic activity surges as production and consumption normalize, and the clean-up and rebuilding activities takes hold. However, the recovery is often unequal and subject to temporary disruptions. For example, shortages are likely until shops manage to restock. Usually, within weeks, economic activity has recovered. The main difference with the current pandemic has been the scale (global vs regional) and the duration (years vs weeks) of the disruption. As a result, the frictions that arise during the recovery from the pandemic have been more broad-based and longer-lasting, compounding to be more impactful.
The frictions and price pressures we are seeing are not mainly demand-driven, something supported by the data. Most countries in the world have yet to fully recover from the pandemic, with the level of GDP still below its end of 2019 level in many cases. This suggests that a decline in global supply is mainly to blame for higher inflation.
A good example of this supply shock is the oil market. On one side, global demand has recovered over the past year, yet has not recovered fully to its pre-pandemic level. On the flip side, supply remains constrained. This is partly due to continued OPEC supply cuts and weak production in other regions, notably US shale oil. As result of this mismatch between demand and supply, oil prices have surged by almost 75% since the beginning of the year to their highest prices since 2014.
However, the oil market is only one of the multiple sources of supply shocks on the global economy. It includes the lack of available containers to bring goods produced in Asia to consumers in North America and Europe, leading to surging transportation costs. The electronic chip shortage constrains production in many sectors, from the car industry to consumer electronics to industrial machinery and home appliances, is also a source of a supply shock. The labour shortage affecting many countries and segments of the labour market is another supply shock on the economy. Poor weather conditions in many regions, from floods in Europe to droughts in North America and Brazil, leading to a very weak harvest season, are pushing food prices higher.
A commonality among all of these shocks is that they are inflationary and constrain economic activity.
Supply vs demand shock: back to Econ101
In the current context, it is important to distinguish how the economy reacts and adapts differently to a supply shock versus a demand shock. Moreover, the difference in the way each type of shock affects the economy will influence policymakers’ reactions required to counteract inflationary pressures.
Here, we go back to the basics, looking at how the economic equilibrium is affected by an inflationary demand shock and an inflationary supply shock.
Inflationary demand shock
An inflationary demand shock, often referred to as a positive demand shock, shifts the aggregate demand curve to the right.
- The result is an increase in economic activity (y) and an increase in price pressures (p). This is typically what would happen if interest rates were cut or the government was to increase spending or give money to households.
- The central bank would normally react to the increase in inflationary pressures by raising interest rates, which would lead to a decline in demand. As a result, economic activity is reduced, moderating inflationary pressures.
Inflationary supply shock
An inflationary supply shock, often referred to as a negative supply shock, shifts the aggregate supply curve to the left.
- The result is a decrease in economic activity (y) and an increase in price pressures (p). This is typically what would happen if a factory is closed or production input becomes unavailable, while consumers still desire to consume the goods and outbid each other.
- As in the case for a demand shock, the central bank would normally react to the increase in inflationary pressures by raising interest rates. The result on the economy would be the same: a decline in demand, a reduction in economic activity and a moderation in inflationary pressures. However, overall, the final equilibrium (y3 and P3) means a lower level of economic activity than in the case of a demand shock.
The fact that a negative supply shock has a bigger negative impact on the level of economic activity also means that the new equilibrium will involve a higher unemployment rate to reduce the inflationary pressures, all else equal. This last part is important because it leads to a trade off for policymakers between tolerating higher inflation and a lower unemployment rate or being more aggressive on inflation and having to tolerate a higher level of unemployment.
Either way, this is unlikely to be a positive outcome for many countries, especially those with high debt levels, as it results in a lower growth rate, higher interest rates and higher unemployment than otherwise would be the case. Canada, with its very high level of household and business debt, would likely under perform in this context.
What type of shock? Permanent vs temporary; additive vs multiplicative
Whether the supply shock is temporary or permanent matters. The previous framework supposes the supply shock is permanent and that the price pressures are long lasting. However, if the supply shock is temporary, the aggregate supply curve will slowly return to its initial point, gradually reducing the inflationary pressures and the need for the central bank to take any actions. Therefore, the debate regarding whether the current supply shock will have a permanent or temporary impact on inflation is crucial.
How long the current supply constraints will last matters greatly. The longer they are present, the more important price pressures will be and inflation remains high. It seems that many of the supply constraints are likely to be affecting the economy until at least the second half of 2022. While this could be viewed as temporary, having inflation remaining higher for longer may have a more permanent impact.
The longer inflation remains high, the more likely economic agents, both businesses and households, will internalize the higher inflation by revising upward their inflation expectations. On the business side, this will lead to more pass-through from higher input prices (energy, commodities, transportation, wages) to output prices, as firms keep their profit margins intact. It is much easier for firms to increase their selling prices when consumers are expecting prices to increase anyway. On the household side, the higher inflation will reduce real wages. Workers will react by demanding higher wages to compensate for the decline in purchasing power. Overall, this situation would result in a lasting increase in inflation.
Another consideration in the current context is that the global economy is affected by a variety of negative supply shocks: manufacturing constraints in many sectors, a surge in commodity prices: especially energy, a jump in transportation costs and acute labour shortages in many sectors and countries. It is not clear how cumulative those supply constraints will be; are they simply additive or are they multiplicative on economic activity and price pressures? The multitude of sectors being impacted just by the chip shortage suggests that the negative impact of those shocks may be more multiplicative than additive.
Policy considerations
Many investors and analysts have been suggesting that central banks should start removing policy accommodations sooner rather than later to fight the increase in inflationary pressures. However, given the nature of the shock, the decision for central banks may not be as easy. As shown previously, in the context of a negative supply shock, there will be a trade off between reducing inflationary pressures and economic activity. More specifically, fighting supply-induced price pressures will mean lower economic activity and a higher unemployment rate than otherwise would have been the case. This is because, to fight the inflationary pressures, the central bank hikes rates, thereby reducing demand, resulting in another decline in output. Ultimately, to reduce inflationary pressures, economic output needs to be sacrificed or, in other words, some slack needs to be created in the economy to compensate for the inflationary pressure due to a reduction in supply.
This trade off is mainly based on a shock that will have lasting impact on inflation. In the case where the supply shock has only a temporary impact on inflation, it would make sense for a central bank to accept higher inflation in the short-term and avoid creating a headwind on growth.
The debate is still raging as to whether the current inflationary environment is temporary or more longer lasting. Central banks are likely to investigate the economic cost of the various policy options that are available. As such, they will consider what is the potential cost of allowing inflation to remain temporarily high versus the cost in terms of lower output from tightening monetary policy. Similarly, central banks will also evaluate the risk to the outlook from waiting to get a better perspective of the permanence of inflationary pressures, such as an increase in wages and inflation expectations, thereby leading to a more permanent inflation process.
The policy mandate of the central bank will likely dictate the preference in terms of policy response. As such, a central bank with explicit full employment mandates, such as the Federal Reserve, is likely to be more patient and less aggressive than a central bank with a strict inflation targeting framework, such as the Bank of England or the European Central Bank. This means that the latter will likely prefer a more proactive approach and is likely to reduce policy accommodation sooner and more rapidly than other central banks. Central banks with flexible inflation mandates such as the Reserve Bank of Australia are also likely to be more willing to allow a rise in inflation and be less aggressive to fight inflationary pressures.
In the case of the Bank of Canada, the central bank’s objective is to keep inflation between 1-3%, aiming at the midpoint of 2%. While this could be viewed as a strict inflation target, history has shown that the Bank of Canada views its inflation target with a certain amount of flexibility. This could allow the central bank some degree of patience in reacting to the high inflation and increase in inflationary pressures to allow the economy to recover further before increasing its policy rate. However, the most recent policy decision suggests that the Bank of Canada may not be willing to use this flexibility and has shown its intent to prevent an increase in inflation. It could also be a tactic to keep a lid on inflation expectations. However, the lack of a full employment mandate means that the Bank of Canada would be more aggressive against inflation pressures than the U.S. Federal Reserve.
Our view of monetary policy remains unchanged at this juncture and we continue to believe that the Bank of Canada will hike rates at the July 2022 meeting. We believe the central bank will use some of its flexibility to support the recovery and expansion from the pandemic-induced recession as long as possible, to lower the amount of slack in the labour market. However, there is a risk that it may need to tighten monetary policy earlier if inflation expectations were to become unmoored. As such, by being patient, inflation may become more entrenched, requiring more restrictive monetary policy at a later date, perhaps through more rapid rate hikes. Whichever path the Bank of Canada decides to take, it cannot escape the trade-off between fighting inflation and supporting the recovery.
Independent Opinion
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