The inflation dragon isn't sleeping anymore

September 16, 2021
David Williams

A generation of Canadians has come to expect low, stable growth in consumer prices. The “inflation dragon” of the 1970s and 1980s was considered slain, or at least sound asleep. The COVID-19 pandemic appears to have awakened the beast.

2021 has seen the fastest consumer price inflation since 2003

Canadian CPI growth soared to 4.1% year-over-year (y/y) in August 2021, more than double the mid-point of the Bank of Canada’s inflation target range of 2% and well outside its total range of 1-3% (Figure 1). This is the fastest increase in consumer prices since 2003. Rising in seven out of eight major categories, the CPI increase was broad-based across major categories (Figure 2) and also across provinces (Figure 3). For B.C., inflation is 3.5% y/y.

Figure 1: The inflation dragon isn't sleeping anymore

The inflation dragon is not sleeping anymore

Figure 2: CPI inflation by category

CPI inflation by category

Figure 3: CPI inflation by province

CPI inflation by province

What’s causing rising inflation and how long will it last?

The Bank of Canada’s view is that recent price pressures are transitory and are due to base effects (low inflation in the middle of 2020), high international commodity prices (affecting input prices), and global supply chain disruptions that will soon sort themselves out. Other contributors are extraordinarily loose monetary and fiscal policy. These policies are creating excess demand in some parts of the economy (e.g. durable goods), even as excess supply persists in other areas and in aggregate.

The “base effect” argument has some merit but is increasingly hard to sustain when month-over-month increases for seasonally adjusted total CPI indicate an increasing trend. This translates to an annualized pace (i.e. the monthly change x 12 months) of around 5% (Figure 4), a figure that is eerily similar to the pace of U.S. inflation (more on this below). Part of this may be described as “catch up” in price levels rather than “base effects”. Nonetheless, there are few signs of price momentum easing in the near term. As noted above, price increases are broad-based and showing “a full head of steam”.

Figure 4: Monthly CPI inflation outcomes are trending up

Monthly CPI inflation outcomes are trending up

Are international supply chain disruptions likely to be transitory? That depends on one’s perspective. Let’s first remember: a) the Bank of Canada’s forecast horizon is only two years – right now, it runs from 2021 to 2023; and b) the impact of monetary policy changes on the “real” economy is generally accepted to take place over a 6–18-month horizon.

In the Bank’s most recent Business Outlook Survey, half of Canadian firms surveyed expected to raise output prices at a greater rate over the next 12 months than over the past 12 months (Figure 5). The other half of firms were roughly evenly split on planning to increase output prices at the same rate or a lesser rate. Similarly, two-in-five firms expect to see stronger input price pressures over the next 12 months compared to the previous 12 months. Only one-in-five expect less input price pressure and three-in-five firms expect input price pressures to continue at a similar rate. This adds up to a bullish outlook for output and input price growth, at least for the next 12 months.

Figure 5: Firms expect faster growth in input and output prices over the next 12 months

Firms expect faster growth in input and output prices over the next 12 months

Similarly, most firms expect CPI inflation to remain near the top or above the Bank of Canada’s inflation target range of 1-3% over the next two
(Figure 6). These expectations span most of the Bank’s forecasting horizon for monetary policy.

Figure 6: Business expectations for CPI inflation over the next two years

Business expectations for CPI inflation over the next two years

A notable piece of evidence supporting the Bank’s view that inflation pressures will be transitory is that around half of firms surveyed expect that, after the next 12 months, their output prices will settle back to pre-pandemic rates of increase. Other firms are not so sure (Figure 7).

It is hard to know how much weight to put on this survey evidence. Firms tend to construct budgets for one or more years ahead. For many, future output prices over the next 12 months can be estimated from recent transactions and from contracts coming due. For more distant years, firms without long term supply contracts have less information and tend to rely on rules-of-thumb forecasts and historical experience. Moreover, many firms are price-takers. They sell all that they produce at the international or domestic market price. They have little individual pricing power and it is their interaction with other firms, globally and domestically, that determines their selling price. In other words, many firms will not know their selling prices two years ahead and at present are using their best guess (i.e. extrapolating from historical experience). This is something the Bank will no doubt be closely watching.

Figure 7: What are firms' expectations for output price growth beyond the next 12 months

What is firms' outlook for their output price growth beyond the next 12 months

U.S. inflation poses risks for Canada’s inflation outlook

Another factor in the Canadian inflation outlook is global inflation, particularly from America. U.S. CPI inflation is at 5.3% y/y in August 2021, the highest since July 2008 (Figure 8). A substantial contributor to the result is energy prices, which have jumped 25.0% y/y. Nonetheless, even excluding energy, U.S. CPI inflation is running at 4.0% - the highest rate in over 20 years. And there are few signs that price pressures stateside are abating. Public health restrictions remain uneven and evolving. Supply chain disruptions are ongoing. U.S. fiscal policy remains extremely loose, as is monetary policy.

Figure 8: Annual CPI inflation in the U.S. exceeds 5% per annum

Annual CPI inflation in the U.S. exceeds 5% per annum


While dwindling labour productivity growth after 2000 has resulted in weak pay growth in Canada (see Williams 2021), the consolation for workers was that the “inflation dragon” of the 1970s and 1980s had been slain, or was at least sound asleep. Yes, wage growth was weak – but so was consumer price growth. Canadian living standards as measured by real incomes weren’t rising much – but at least they weren’t falling.

COVID-19 appears to have awakened the inflation dragon from its long slumber. The Bank of Canada expects the dragon’s wrath to persist throughout 2021, with the beast becoming drowsy again towards the end of 2022. This relatively benign outlook is subject to considerable uncertainty.

First, COVID-19 public health restrictions in Canada and abroad continue to evolve, creating uncertainty. Second, international shipping and supply chain disruptions are ongoing and appear unlikely to be fully resolved until 2023 at the earliest. Third, monetary and fiscal policy in Canada and the U.S. remain extraordinarily loose, even as much of the initial economic slack created by the COVID-19 shock has disappeared. Fourth, Canada’s federal government unwittingly increased immigration targets during a period of weak or recovering labour demand. This is exacerbating excess labour supply (i.e. unemployment/underemployment). Ultra-loose monetary policy is now needed for longer to boost labour demand to try to absorb the extra labour supply, but at a cost of exacerbating other serious economic imbalances such as record levels of public and private indebtedness. Unwinding all the imbalances in the Canadian economy could prove difficult. Fifth, structural policy settings and current policy trends in the U.S. and Canada are likely add to costs of production and consumption as they are not geared towards raising productivity and reducing business costs. Finally, high inflation could become self-reinforcing if a wage-price spiral develops (although there are few signs of it yet) or if the inflation expectations of firms and households become “unanchored” (i.e. move away from central banks’ inflation target).

Canada needs a serious policy debate about how to raise labour productivity growth so that pay growth stays ahead of the (now escalating) cost of living. Unless current nominal wage growth increases to at least match inflation, Canadian real incomes and living standards are set to fall. As election day approaches, this is something the federal political parties and their candidates should be discussing.

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