October 24, 2022
Unless you have been living under a rock for the past year or so, you will have noticed almost all goods and services costs more today versus a year ago. It costs more to buy food, fill up gas, pay bills and make rent. Canada and many countries around the world are experiencing the same phenomenon.
The Bank of Canada defines inflation as a persistent rise in the average level of prices over time. Inflation in Canada came in 6.9% year-over-year for the month of September. This is the highest level we have seen in the past 20 years and a level we have not witnessed since the 1980s.
US inflation is at 8.2% Y/Y for September and tells a very similar story.
Central banks around the world have acted by increasing interest rates to combat inflation. Higher interest rates would encourage saving and discourage borrowing and spending which in turn would incentivize companies to lower prices in good and services. But why have prices remained stubbornly high? To answer this question, we need to realize there are two types of inflation: supply-side (also called cost-push inflation) or demand side (also called demand-pull inflation) effects.
Demand side or demand-pull inflation is fairly intuitive. Let’s take a simple example of purchasing shoes. If suddenly, people decided to purchase more shoes in your city, then the province and then the country, it would drive up the price of shoes. More money (people) chasing fewer goods drives up prices. Shoe prices would become inflated. The central bank would eventually raise interest rates forcing all interest sensitive products like loans, mortgages, credit cards, and savings accounts to increase. This incentivizes the consumer to allocate money to these areas and/or save it instead of buying shoes. Demand falls and shoe prices begin to moderate until a healthy balance is achieved.
Supply side or cost-push inflation is different. It is caused when there is a disruption in the supply of goods or services and/or an increase in the cost of production. In other words, not caused by your own demand but something out of your control. Let’s take food prices as an example. Russia and Ukraine are large exporters of wheat. The war has disrupted wheat supply chains resulting in less bread, pasta and cereal being produced meaning less supply and higher prices. You have not decided to eat more food, but your grocery bill is now higher versus previous years.
The Russian/Ukraine conflict has also impacted energy prices which also contribute to higher food prices. Why? Russia is a large producer and exporter of oil. As countries boycott Russian oil, it curtails oil supply and drives up fuel prices resulting in higher transportation costs for all ships, trucks and trains transporting food around the world. Higher fuel costs are passed on in higher food prices and borne by the consumer.
An example of supply disruption is China’s zero COVID policy. China is the number one exporter of goods to the world. Let’s take an example of furniture. If China temporarily shuts down its manufacturing supply chain, furniture cannot be produced and exported around the world resulting in less goods and thus higher prices. You have not decided to buy more bed frames, sofas or bookcases than normal, yet these items cost more at the store.
The central banks main tool is to raise interest rate to combat inflation. We believe this is effective when inflation is largely demand side driven but unfortunately, today’s inflation is mainly supply side induced. A higher interest rate alone is unlikely to end the effects that Russia’s invasion of Ukraine and China’s COVID policies have on prices. In the meantime, other policies have been introduced to combat supply side inflation. The US for example has released oil from its strategic petroleum reserve to increase oil supply into the market. More oil means more fuel supply to help with rising transportation costs and pump prices.
Ultimately, a resolution of the war would go a long way to solving energy and food inflation. China relaxing its zero COVID policy would allow factories to open and produce more goods. If exports ramp up again, this too should help alleviate inflationary pressures.