Prices may be rising, but here’s why Stephen Poloz isn’t too concerned about it

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Few Canadians have devoted more effort to fighting inflation than Stephen Poloz. He conducted much of the research that persuaded his bosses at Bank of Canada to embrace an inflation target in the early 1990s and use the Consumer Price Index to guide their thinking about where to set interest rates. A couple of decades later, he took over the central bank, taking charge of the policy regime he helped create as a young researcher.

Poloz’s tenure as governor was bookended by the aftermath of the Great Recession and the first few months of the COVID-19 crisis. The CPI’s year-over-year change averaged 1.6 per cent per month during his seven years as boss, slower than the target of about two per cent. That shows he didn’t have a heavy foot on the accelerator. Some economists even think he could have been more aggressive. The record suggests Poloz preferred to err on the side of keeping inflation contained.

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At the end of 2019, Poloz observed that the “risk of an outbreak of inflation remains low, but still seems higher than it has been over the past 30 years.” The remark stood out because few were talking about inflation at the time. The CPI was holding steady and the Bank of Canada kept its cool when many central banks had cut interest rates earlier in the year. Prices were under control.

Now, inflation is all people want to talk about. It’s difficult to have a conversation without someone bringing up the cost of lumber. Stock markets plunged on May 12 after the United States government released data that showed its CPI increased 4.2 per cent in April from a year earlier, the most since 2008 and more than many on Wall Street had anticipated. The report bolstered arguments that the extraordinary stimulus central banks and governments have pumped into their countries to offset the effects of the pandemic was finally causing economies to overheat.

Is Poloz worried? Not really. His 2019 comments were based on changing political attitudes that he said could lead to a structural shift in government spending and public debt. But that’s a longer-term trend. He sees the current burst of inflation as transitory.

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“It’s something that we have to take seriously,” Poloz, who now is a special adviser at law firm Osler, Hoskin and Harcourt LLP, told the Financial Post’s Larysa Harapyn this week. “But most of the signals right now are coming from commodity markets, which are perfectly naturally rising.”

The Bank of Canada’s monthly commodity price index was 121 per cent higher in April than a year earlier. That increase is exaggerated by the math typically used to track price changes. April 2020 aligned with the worst of the COVID-19 crisis, when prices had collapsed, so current readings are being skewed by base effects. Still, anecdotal evidence of supply shortages for vital inputs is real. The central bank’s measure of commodity prices climbed 23 per cent this year through April.

“I don’t wish for inflation. I don’t want inflation. I do think inflation is going to come. It has to come,” Mark Barrenechea, chief executive at Open Text Corp., a Waterloo, Ont.-based software developer, said in an interview on May 7. “You are already seeing it in fundamental items: shipping, containers, fuel costs, the lack of petrochemical elements out of Texas, lumber costs going up. I do think inflation will come in.”

To some extent, central banks are counting on it. A year ago, the Bank of Canada was worried about deflation. That’s why it dropped its benchmark interest rate to a record low and began using its unique power to create money to buy bonds. Getting inflation back to two per cent was the objective.

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Financial markets worry that the central banks overdid it. But Poloz doesn’t think so. He reckons the world is simply finding its way back to a new balance of supply and demand. Prices for some goods and services might settle at a higher level than before the pandemic, but the rapid increases that companies are coping with currently will subside.

“A lot of sectors stopped work, let inventories run down during the pandemic and now we’re getting excess demand,” Poloz said. “But on the other side of every expansion of demand in the commodity sector, what you get is an expansion of supply. So, I suspect that is a very temporary phenomenon.”

The industrial capacity utilization rate, a measure of the gap between actual production and what industry could produce if it maxed out its facilities, plunged to 71.4 per cent in the second quarter of 2020, from about 81 per cent in the first quarter, according to Statistics Canada. The figure had only climbed back to about 79 per cent by year-end, which is the most recent data available.

“In terms of the economy, we know there is excess capacity, so we know we have room to grow before we actually have fundamental inflation pressures,” Poloz said.

The trajectory of inflation will ultimately be determined by Barrenechea and thousands of other executives who will now decide whether to absorb rising input costs or raise their own prices. Barrenechea said technology companies tend to do well during inflationary periods because their input costs are relatively low, so higher prices amount to windfall profits.

Open Text hasn’t raised its prices, but, like the central banks, its leaders are watching the CPI.

“When inflation does happen, it will actually help revenues,” Barrenechea said. “We’ll raise our prices as well. We won’t lead in that, but we’ll be a fast follower.”

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