Inflation slows, but prices can’t just go back

Opinion

Hey there, time traveller!
This article was published 21/11/2024 (324 days ago), so information in it may no longer be current.

American voters have spoken in a fashion that might be a mystery to many of us, but which reflects significant dissatisfaction with the economy that resonates among Canadian voters in recent polls. Although inflation has returned to the Federal Reserve and Bank of Canada’s target of two per cent, consumers grumble that “prices are still too high” and wonder why prices can’t return to pre-pandemic levels. Arguments of a victory over inflation are scoffed at when prices are almost 20 per cent higher than in 2019.

My first real job at the Bank of Canada in 1971 introduced me to the arcane workings of monetary policy, but I soon fled to the safer confines of graduate school overseas and the study of labour markets.

Over the years, monetary policy became simpler and more direct, concentrating on price stability through manipulation of the overnight rate that influences short-term interest rates and bond yields. Policy is also now much more transparent as the interest rate response to achieve the inflation target is regularly discussed, announced and explained to the public. None of that occurred in the 1970s, when inflation soared across more than a decade amidst monetary policy confusion.

While there is now general consensus that price stability is important to the effective operation of a market economy, it is less clear why the target should be two per cent inflation rather than no inflation (pure price stability) or even lower prices (deflation). After all, if price stability is a good thing, why is a little bit of inflation, but not too much, a better outcome?

When the Bank of Canada set its original inflation target in 1991, it was a range of two to four per cent that would gradually fall to the now familiar one to three per cent by 1995. The inflation target has been reconsidered every four or five years since then, most recently in 2021 for a five-year term.

A labour economist would not expect to have anything further to do with monetary policy or the Bank of Canada. Studying labour markets, however, led to the puzzle of downward nominal wage rigidity, or more colloquially “sticky wages.” Although economic models usually started by assuming that wages could easily fluctuate up and down, examination of Canadian wage settlements consistently found evidence of significant resistance to pay cuts even under adverse economic conditions and rising unemployment.

When inflation declined dramatically in the 1990s, as low as 0.2 per cent in 1994, it created pressure on workers in weaker industries to accept pay cuts rather than simply fall behind rising prices. The absence of pay cuts under low inflation, however, could lead to reduced employment and output in these industries and stunt the reallocation of resources to prospering sectors of the economy. Research with colleagues found that private sector wage stickiness retarded employment growth and increased unemployment during the low-inflation period from 1993 to 1995.

Although the direct evidence for resistance to price cuts is less clear, there is evidence that prices are also resistant to change, particularly downward. Conferences at the Bank of Canada have regularly discussed the issues around downward nominal wage and price rigidity and found the evidence sufficient to maintain the inflation target of one to three per cent, rather than adopt a lower target such as zero inflation, or price level targeting.

An additional concern with a lower inflation target is that it could lead to a bout of price deflation.

If consumers see prices falling and expect them to continue falling, they postpone expenditures, the demand for goods and services falls, and employment falls. Moreover, declining prices make debt more expensive, leading people and businesses to avoid borrowing and investment and to hold more cash. Reduced employment, output and investment can precipitate a deflation spiral that is hard to stop.

Just ask Japan, which recently celebrated a return to mild inflation after more than two decades of deflation and stagnation.

Since the phenomena of pay-cut and price-cut resistance cannot be legislated or wished away, and since the dangers of deflation seem very real, the alternative is to allow a small amount of inflation to ensure conditions that promote economic growth. This is what advanced market economies have been doing since the 1990s. This policy has been largely successful in avoiding both runaway inflation and deflation to promote economic progress, leaving it to governments to protect those most vulnerable to inflation (or not).

So prices will not go back to where they were and we are very likely better off for it. One of the many puzzling aspects of the decision of the American electorate was to support an economic policy of tariffs, unfunded tax cuts, and possibly interference with the Federal Reserve’s authority to control interest rates and inflation.

This could have renewed inflationary consequences that, once unleashed, would be painful and difficult to reverse.

Wayne Simpson is a retired professor of economics at the University of Manitoba.