Excessive demand fueling inflation and it won’t last

Inflation is a difficult beast to control. Usually, it is described as too many dollars chasing too few goods, causing markets to react by bidding up the prices of both goods and services.

In theory, higher prices moderate demand. In this sense, the system tends to adjust through the magic of the pricing mechanism. But what if this isn’t enough?

The way to shut down unusually high inflation is to raise interest rates, thus cutting back the demand for loans.

With decreased access to borrowed funds on the part of both businesses and consumers, demand for good and services decreases. Another effective anti-inflationary instrument is a tax increase that reduces the money held by both consumers and business; again, demand decreases.

But, for these measures to work efficiently, we have to assume that goods consumed in Canada originate in Canada and that the price of Canadian goods is determined by domestic factors. Unfortunately, that is not the case.

While most services we consume are produced domestically, most of the goods we consume are not. Energy, particularly oil and natural gas, are global commodities and subject to price pressures beyond control of Canadian governments or businesses.

When Russia decided to invade Ukraine, the international price of oil rose like a rocket and gasoline quickly blew past $2.10 a litre. That, in turn, impacted the cost of distributing products across this vast land.

The cost of international shipment of goods by sea also rose because of higher fuel costs. Moreover, higher fossil fuel prices also pushed up the costs of operating farms which, together with the adverse impact of a prolonged drought in western North America, cut into the size of crops. Hence upward pressure on food prices.

The ending of travel restrictions related to the COVID-19 pandemic set off a boom in demand for travel, particularly air travel. Airlines suddenly faced a tsunami of demand for seats as consumers rushed to make that long-postponed visit to family and friends or simply take a long-postponed vacation.

The tsunami caught the airlines understaffed. They laid off workers when the pandemic hit and public health officials cut off unnecessary travel. It takes time to staff up. If you think the resulting chaos in major airports was bad, just imagine what it would have been like had the airlines not faced steep increases in the cost of fuel leading to higher ticket prices for the travelling public.

Pandemic restrictions also affected social functions from concerts to sporting events. Downtown business districts took on a ghost-like atmosphere as workers stayed at home. When the restrictions were lifted, demand from both business and consumers increased quickly while rehiring of laid off workers lagged.

Thus, demand exceeded supply for a time and that put upward pressure on prices.

So, is inflation here to stay? Are we in for a prolonged spell of rising prices on virtually everything? The short answer is “no.”

Working from home rather than in an urban centre office tower is likely going to be more common than it was before the pandemic hit, even as many businesses ask workers to return to the office at least part of the time.

So kilometers of commuting will be reduced. Also, notice that the price of gasoline has declined well below $2.

Bottlenecks in production are easing and transport costs, particularly for ocean shipping, are declining. Auto prices both for used and new cars are staring to ease.

All of these adjustments take time but we see in the latest inflation figures that the month-to-month change is slowing down appreciatively.

Prices are still higher than they were a year ago but the rate of increase is moderating. In brief, the economy of Canada and the world is adjusting to a fast-changing reality.

So inflation of the most recent annualized rates of 8% or more will not be the norm. But it will take a while (I think by the end of the first quarter of 2023) to get back to 2% to 3%.

The big challenge ahead is addressing the labour shortage. Increasing participation in the labour force takes time. For individuals, it frequently involves a change in lifestyle or location and retraining.