The Bank of Canada’s decision on Wednesday to start raising its target for the overnight rate of interest reflects its recognition that inflation has turned out to be higher and more persistent than it had been expecting, and that slack in the economy has now been absorbed, also faster than expected: as recently as December the bank had predicted slack would persist until the middle of this year.
Wednesday’s announcement stressed supply-side factors as the main reasons for high inflation: poor harvests and higher transportation costs, and higher energy and food-related commodity prices resulting from the invasion of Ukraine.
But there is another, often-neglected, demand-side factor that will maintain upward pressure on inflation: the extraordinary surge in money that has occurred in Canada since the pandemic started, and the likelihood that some of the money that has been pooling in Canadians’ bank accounts will begin circulating, boosting spending.
The kinds of money that matter most for spending and inflation are the kinds that people and businesses can easily spend. Economists categorize different monetary aggregates, like M1, M1+ and M2++, according to how liquid they are, with the higher number (and additional plus signs) indicating the inclusion of less and less liquid assets. The growth rates of virtually all these monetary aggregates shot up starting in February 2020, and peaked a year later, with year-on-year growth of M1+ exceeding 30 per cent in January 2021.
These aggregates ballooned because tens of billions of COVID-related emergency transfers were going into Canadians’ bank accounts and also because of low interest rates, which encouraged Canadians to borrow. When a bank lends, the loan shows up in the borrower’s bank account as a deposit, which increases the money supply.
The household savings rate in the second quarter of 2020 reached an unprecedented 28.2 per cent, and remains high today relative to recent norms. Some of that money has supported spending already. Many households decided to buy a new house or renovate an old one, contributing to rapid run-ups in the prices of housing and building materials. But much of the rest they parked in liquid assets, including components of the money supply, to await the day when spending on things like restaurants and travel became either easier or feasible at all.
Money growth has slowed from its peak a year ago but is still robust. And with pandemic uncertainty declining, this big pool of money is now beginning to move. Over the last few decades, the velocity of money’s circulation — the rate at which a given stock of money moves through the economy — has gradually but steadily trended downward, in large part because low global interest rates have reduced the opportunity cost of holding more liquid assets. Then, during the pandemic, the demand for liquid assets soared and velocity plummeted as people willingly built up their bank account balances.
Velocity is now slowly beginning to return to pre-pandemic trends. As it does, and with the economy operating at capacity, either the over-sized money supply is going to have to fall or prices will go up, which will stoke inflation and the growing inflationary psychology.
The economy’s big liquidity overhang suggests we may be in for more nasty inflation surprises in the near future. The Bank of Canada’s monetary tightening has likely only begun.
Steve Ambler, a professor of economics at the Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, where Jeremy Kronick is associate director, research.
