Inflation is the rate of increase in the prices of goods and services over a period of time. The main indicator of inflation is the Consumer Price Index (CPI), which is a “basket” of common purchases made by consumers. The CPI includes food, clothing, living expenses, medical care, recreation, education, communications, transportation, etc.¹ The basket is kept consistent over time for comparability of inflation readings. It is occasionally updated to reflect consumption trends.²

In times of high inflation, consumers experience an erosion of their purchasing power because increases of disposable income³ rarely offset the higher costs of goods and services. This situation results in a decrease of consumer demand for goods and services, and a lower standard of living. Businesses are also affected because they have higher operating costs. They are often unable to increase their prices enough to compensate for higher costs, because doing so makes them less competitive. Irrespective of their ability to increase prices, all businesses are negatively impacted by the overall diminishing consumer demand for goods and services.

Left unchecked high inflation becomes entrenched, feeds on itself and can spiral out of control. Employees expect ever higher salaries and wages to compensate for the erosion of their purchasing power. Businesses continue to increase prices to offset higher operating costs. All of these effects can lead to hyperinflation, namely rapid, excessive and out-of-control price increases. In turn, hyperinflation can result in a loss of confidence in the value of a currency relative to others.

It is understood that low, stable and predictable inflation is best for the economy. Central banks have traditionally maintained a target range of 1 to 3% for inflation, which is optimal. An annual inflation rate of 2% is considered to be an adequate level of price stability in a healthy economy.⁴

Current Inflation Problem

Current inflation rates in the United States, Canada and Europe (hovering between 7% to 10%) continue to be well-above traditional targets for the second year in a row. In 2021, central banks misread high inflation as “transitory” due to higher consumer demand following the end of pandemic lockdowns. As the high inflation persisted during 2022, central banks came to realize that they have a major and pressing problem to deal with. Figure 1 illustrates annual rates of inflation in the United States since 2015. The annual rate was 7% in 2021. It was 8.3% at the end of August.

Drivers of Inflation

According to the International Monetary Fund (IMF), the drivers of inflation are: 1) lax monetary policies; 2) supply-demand imbalances; 3) expectations of continuing inflation; and 4) central bank credibility in maintaining price stability.⁵ The current context of these drivers is as follows:

• LAX MONETARY POLICIES – Record low short term interest rates fueled by near zero central bank policy rates, and very low long term interest rates driven by massive amounts of quantitative easing⁶ reveal extremely aggressive monetary policies since 2010. These monetary policies augmented money supply to maintain economic growth. However, excessive money supply causes inflation, along with artificially high stock market and real estate values. To put things in perspective, the current policy rate of the Federal Reserve of the United States continues to be very low by historical standards despite recent increases (Figure 2). In addition, the massive holdings of investment securities amassed by the Federal Reserve as part of its quantitative easing totaled $8.6 trillion at the end of December 2021, representing 37% of the U.S. economy, and 30% of U.S. federal government debt. The near zero Federal Reserve policy rates and the massive amounts quantitative easing expose the unprecedented scale of the monetary stimulus that has taken place since the financial crisis of 2008-09.

• SUPPLY-DEMAND IMBALANCES – Excessive demand and/or limited supply of goods and services create imbalances that cause inflation. Most economists agree that the current inflation is not so much a problem of excessive demand. It is mostly a problem of limited supply, caused by supply chain issues and diminished production capacity due to the pandemic. The war in Ukraine also reduces supply, given trade embargos on Russia, and challenges for Ukraine to maintain its production and exports. The dependence on Russian oil and gas is a major driver of energy inflation in Europe. Droughts and extreme weather events causing flooding are also major problems limiting food supply, while increasing demand for reconstruction. Tight labor markets in the United States, Canada and most parts of Europe also contribute to the problem of limited supply, as many jobs remain unfilled due to skilled labor shortages. The reshoring of supply chains and production away from high risk countries adds to the ongoing labor shortages in western economies. Declines in the labor participation rate further aggravate labor shortages. Aggressive fiscal stimulus by governments adds to the current imbalance if it drives consumer spending instead of business investment.

• EXPECTATIONS OF CONTINUING INFLATION – Expectations of continuing inflation are a major source of worry by central banks. After almost two years of high inflation, consumers are feeling the pinch and employees are demanding salary and wage increases in line with inflation. Higher compensation levels fuel inflation because they stimulate demand for goods and services, and they increase production costs that need to be passed on to consumers for businesses to remain profitable. If central banks fail to eliminate inflation, it becomes entrenched. When this happens, restoring price stability is even more difficult and painful.

• CENTRAL BANK CREDIBILITY – Expectations of low inflation rest upon the credibility of central banks to maintain price stability. Without credibility, expectations of high inflation become rampant. Central bank credibility has taken a hit since 2021, when chief bankers suggested that inflation was “transitory” due to the end of pandemic lockdowns. Central banks are now in catch-up mode with policy rate increases that mainly affect short term interest rates. However, they are unwilling to reverse their quantitative easing to increase long term rates. Doing so would result in steep accounting losses because the market value of the investment securities that they hold has become lower than book values. The current approach by central banks is to let these investment securities mature without fully replacing them. Central banks do not record their investments at the lowest of cost and market value. They readily admit that this accounting treatment is not consistent with generally accepted accounting principles (GAAP).⁷

Central Bank Commitments

Lax monetary policies and supply-demand imbalances are the main culprits of inflation at this time. However, unless these two major issues are addressed promptly and vigorously, expectations of continuing high inflation will become entrenched, and central bank credibility will undoubtedly take another hit. This nightmare scenario is cause for concern.

Central banks worry that inflation may become entrenched. “Our job is literally to prevent that from happening. And we will prevent that from happening” recently said Jerome Powell, Chair of the Federal Reserve.⁸ The Federal Reserve is committed to bring inflation back to its 2% target, even if it causes unemployment and a recession. “These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain. (…) Without price stability, the economy does not work for anyone” said Mr. Powell at a recent symposium of central bankers.⁹

Andrew Bailey, Governor of the Bank of England, made the following remarks in a recent speech to finance professionals: “Our job is to hit the inflation target, and in the current circumstances to return inflation to target (…). Let me be quite clear, there are no ifs or buts in our commitment to the 2% inflation target. That’s our job, and that’s what we will do.”¹⁰ Tiff Macklem, Governor of the Bank of Canada also believes that bringing inflation back to the 2% target is imperative. “It will take some time before inflation is back to normal. We know our job is not done yet – it won’t be done until inflation gets back to the 2-per-cent target” Mr. Macklem said recently.¹¹

Some current and former central bankers express doubt that inflation can be restored to the 2% target because of the structural changes driving supply-demand imbalances. “I don’t think that we are going back to that environment of low inflation” said Christine Lagarde, President of the European Central Bank.¹² Mark Carney, former Governor of the Bank of England and Bank of Canada remarked earlier this year: “the global economy is undergoing a series of major transitions. The long era of low inflation, suppressed volatility and easy financial conditions is ending.”¹³

Bond Market Readings

Bond yields have traditionally been an accurate predictor of recessions in the past. A yield curve indicates the investment return of bonds across maturities, ranging from one year or less, to thirty years or more. In normal times, yields are higher for longer maturities. An upward yield curve indicates that the economy is expected to grow. A downward (inverted) curve indicates that a recession is forthcoming. The current United States government bonds yield curve (Figure 3) has a downward slope for maturities in the 1 to 10 year range, which suggests that a recession is expected. The downward slope of maturities in the 20 to 30 year range reflects a higher demand for long term bonds, which is pushing yields a bit lower for 25 and 30 year maturities.

The entire yield curve moved upward during August 2022. This move indicates that bond markets expect higher interest rates now and in the distant future. The rise of bond yields across all maturities implicitly suggests that higher interest rates will be required to control inflation going forward, and that very lax monetary policies are not expected to resume in the future.

Stock Market Reactions

Stock markets tumbled by 4% following comments by Jerome Powell that the Federal Reserve is  strongly committed to reducing inflation back to its 2% target. Approximately $1.5 trillion of market capitalization vanished as a result of the drop. Stock markets were taken off-guard. The anticipation that interest rate increases would soon taper off subsided. “Ever since Chairman Powell’s speech, the market has refocused on the macro environment and monetary policy. With the Fed being aggressive again, that cloud of uncertainty is weighing on the markets,” observed Yung-Yu Ma, Chief Investment Strategist at BMO Wealth Management.¹⁴

Despite the recent stock market sell-offs, some analysts believe that future interest rate increases and recession risks are not entirely factored in the current prices of equities. According to Sameer Samana, Senior Global Market Strategist at Wells Fargo Investment Institute, the stock market continues to be “incredibly expensive” when compared to the current 10-year bond yield.¹⁵

United States treasuries are a benchmark for safe investments. The more that bond yields rise, the more that equity risk premiums have to increase, putting downward pressure on stock valuations.¹⁶ The 17% stock market correction since December 2021 (Figure 4) follows an increase of 50% that took place during the pandemic. This significant increase was fueled by record low interest rates and massive government spending. The 17% stock market correction since January 2022 is likely just the first phase of additional ones to come. The extremely lax monetary policies that fueled stock markets and real estate values in the past 10 years are unlikely to repeat themselves. There may be a painful reckoning on this front, as stocks and real estate values readjust to a new reality.

Difficult Task Ahead

Current inflation pressures will not subside on their own. Central banks know that restoring price stability is imperative. Allowing high inflation to remain leads to disastrous economic consequences. Whether price stability will be restored at the 2% inflation target in the short term remains to be seen. Most central bankers leave not doubt that they will do everything required for this to happen. Others believe that higher inflation may have to be tolerated in the future. In any event, it is clear that a reset of monetary policy is underway. What is less clear is whether monetary policy will be as effective in the current context of supply-driven inflation, as it has been in the past with excessive demand. The current situation requires reducing pent-up demand to match limited supply. The ways out of the financial crisis and pandemic were to lower interest rates, increase money supply, and boost government spending. That was easy. Doing exactly the opposite is now required.

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¹ U.S. Bureau of Labor Statistics, “Consumer Price Indexes Overview” (August 19, 2022, www.bls.gov/cpi/overview.htm)
² Ceyda Oner, “Inflation: Prices on the Rise” (International Monetary Fund, Undated, Accessible though: www.imf.org)
³ Disposable income is the amount of money left to spend and save after income tax has been deducted.
⁴ McKinsey & Company, “What is inflation?” (August 17, 2022, Article accessible through: www.mckinsey.com)
⁵ Ceyda Oner, “Inflation: Prices on the Rise” (International Monetary Fund, Undated, Accessible though:www.imf.org)
⁶ Quantitative easing refers central bank purchases of treasuries to drive-up bond prices and lower long term interest rates.
⁷ Federal Reserve Banks, “Combined Financial Statements” (Dec 31, 2021, Accessible through: www.federalreserve.gov)
⁸ Nick Timiraos, “Jerome Powell’s Dilemma: What if the Drivers of Inflation Are Here to Stay?” (The Wall Street Journal, August 24, 2022, Accessible through www.wsj.com)
⁹ Howard Schneider and Ann Saphir, “Fed’s Powell Sees Inflation Battle Lasting ‘Some Time,’ Warns of Economic Pain” (Financial Post, Accessible through: www.financialpost.com)
¹⁰ Andrew Bailey, “Bringing inflation back to the 2% target, no ifs no buts” (Speech by Andrew Bailey, Bank of England, July 19, 2022, Accessible through www.bankofengland.co.uk)
¹¹ David Parkinson, “BoC’s Macklem Needs to Soften His Message Around Inflation” (The Globe and Mail, Ontario Edition, August 18, 2022, Accessible through: www.theglobeandmail.com)
¹² Nick Timiraos, “Jerome Powell’s Dilemma: What if the Drivers of Inflation Are Here to Stay?” (…)
¹³ Nick Timiraos, “Jerome Powell’s Dilemma: What if the Drivers of Inflation Are Here to Stay?” (…)
¹⁴ Hannah Miao and Caitlin Ostroff, “Stocks Finish Lower as Investors Brace for More Fed Tightening” (The Wall Street Journal, August 30, 2022, Article accessible through www.wsj.com).
¹⁵ Lewis Krauskopf, “Fed spurs worries over U.S. stock valuations” (The Globe and Mail, Ontario Edition, September 1, 2022, Accessible through: www.theglobeandmail.com)
¹⁶ The Capital Asset Pricing Model outlines the formula for calculating the risk premiums of individual stocks.