Canada | The risk of stagflation increases

As economic growth falters and inflation remains stubbornly high, Canada appears to be heading for a new phase of stagflation, the last episode of which dates back to the 1970s, economists are observing.

Posted at 2:43pm

Brett Bundale
The Canadian Press

The anomalous mix of price hikes and high unemployment captured the country’s collective imagination some 40 years ago. Supply shocks had pushed up energy costs, interest rates had reached devastating heights and unemployment was widespread.

Today, some experts point out that the conditions for a return of this economic phenomenon are in place.

“I would say that next year we expect a recession in this country which, combined with persistent inflation, could lead to stagflation,” notes Armine Yalnizyan, economist and fellow of the Atkinson Foundation.

“We cannot dodge the global forces that are pointing to a recession […], the question arises as to whether rising interest rates will curb inflation. »

But this return of stagflation may represent a milder version of this economic anomaly.

“I don’t think it’s unrealistic to expect a world where inflation and unemployment will rise,” said Fred Bergman, senior policy analyst at the Atlantic Provinces Economic Council, an independent think tank firm based in Halifax.

“We could see these two (elements) climbing together, which is rare. But it will be very modest compared to what we saw in the 1970s and 1980s.”

The enigma of stagflation

The simultaneous rise in inflation and unemployment confused economists and politicians in the 1970s.

Any Economics Course 101 would say that the macroeconomic problems of inflation and unemployment have an inverse relationship. This high inflation occurs during periods of low unemployment and vice versa.

Stagnation reverses this theory by associating high inflation with increased unemployment and slower growth.

Its resolution is a mystery. Levers to fight inflation could slow the economy and send unemployment skyrocketing, while efforts to stimulate economic growth could drive higher prices.

“It creates a kind of swamp for politicians,” observes Mr. Bergman. Reversing the inverse relationship between unemployment and inflation creates a political dichotomy. »

The challenge for the Bank of Canada is to raise interest rates enough to control inflation without triggering a recession.

In an unprecedented move, the central bank hiked interest rates to 1.5% for the second time in two months on Wednesday.

But no one knows if this will be enough to dampen inflation.

Absence of “stagnant aspects”

Annual inflation hit 6.8% in April, marking the fastest year-on-year rise in consumer prices in more than three decades.

Finding the ideal interest rate level is complicated by the fact that there is a lag effect between higher interest rates and the impact on consumer spending and business investment.

“You’re walking on a wire, and it’s a bit of a balancing act,” illustrates Mr. Bergman. We’ll see the economy slow down and […] we could find ourselves on the brink of a recession. »

In a speech last month, Bank of Canada Deputy Governor Toni Gravelle said comparisons between the current acceleration in inflation and the period of stagflation in the 1970s were unwarranted.

“They don’t see the stagnant aspects of stagflation – quite the opposite,” he said. Many indicators suggest that the Canadian economy is running at full speed. »

While higher interest rates will reduce demand and slow growth, they should also reduce inflation – reducing the inflationary component of stagflation, he explained.

The problem is, economists argue, that may not be the case.

Some factors driving prices higher in Canada are likely to continue despite rate hikes.

“There are other forces that could keep inflation high even as the economy slows,” warns Nicolas Vincent, economics professor at HEC Montreal.

“We continue to be hit by supply shocks. »

Russia’s invasion of Ukraine, China’s COVID-19 lockdowns and supply chain delays are driving price hikes.

These situations are likely to continue.

“The invasion of Ukraine and the experience of China mean that we have to wait at least another year for price pressures to subside,” said M.me Yalnisyan.

“The simplest tools we have in our toolbox are central bank policies, which themselves will slow growth, but they can make things worse, not better. […] it’s a tightrope walk. »

The problem of stagflation that began in the 1970s only ended in the early 1980s, when the Bank of Canada raised interest rates to a point where the federal funds rate rose to over 20%, the Conference Board of Canada pointed out in a current analysis.

“Inflation and inflation expectations eventually plummeted, but that came at the expense of a brutal recession that caused the unemployment rate to hit 12% in the early 1980s,” the Conference Board said in its March report.

In other words, the tool used to correct inflation could cause almost as many problems in other areas.

Unemployment rate at record low

Still, some conditions today differ from those of the 1970s and could help Canada avoid stagflation.

Canada’s unemployment rate fell to a record low of 5.2% in April, Statistics Canada reported last month.

The strength of the job market and ongoing labor shortages in several industries across the country stand in sharp contrast to the high unemployment rate recorded when baby boomers were young four decades ago.

“The job market is really active,” says William Robson, president and CEO of the CD Howe Institute, a Toronto-based research group.

“There are parallels with the 1970s, but our unemployment rate is much better. »

Demographics and an aging population will also help keep unemployment in check, he says.

Canada could benefit from the continued rise in commodity prices, which could even lead to a larger trade surplus.

The country is also less unionized and fewer cost-of-living allowances are included in collective agreements and contracts.

“In the past, workers tried to catch up with price increases, otherwise they would lose purchasing power,” she says.me Yalnisyan. This had led to a price-wage spiral in which one further fueled the other. »

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