When Thomas Hoenig took over as president of the Federal Reserve Bank of Kansas City nearly two decades ago, his 85-year-old neighbour gave him a 500,000-mark German banknote to remind him of Germany’s experience with runaway inflation following the First World War. “He told me that in 1921, the note would have bought a house,” Hoenig said during a recent speech to a U.S. budget commission. “In 1923, it would not even buy a loaf of bread. That note is framed and hanging in my office.”
Hoenig openly admits that invoking historical reminders of hyperinflation might seem overly alarmist in an era when inflation—a rise in the cost of living caused by heightened demand for products or the rising cost of producing them—has ceased to be a major concern for most North Americans. Central bankers have made fighting excess inflation, usually anything more than two per cent to three per cent, among their chief priorities in recent decades (some inflation is generally viewed as a good thing because it signals economic growth). But as the economy comes back to life after an extraordinary period that saw governments—particularly in the United States—resort to unprecedented fiscal and monetary measures to keep the world’s economies from imploding, suddenly there’s renewed concern about inflationary pressures. (Already, Canada saw a surprise jump in its inflation rate in January.) With all that extra money sloshing around in the system—inflation is sometimes thought to be caused by too many dollars chasing too few products—some are worried that the cure prescribed for the downturn could quickly become the recovery’s disease.
While unwanted inflation can be reined in by hiking interest rates, central bankers seem intent on keeping interest rates low to help speed economic recovery. People like Hoenig, meanwhile, say they are worried that a massive buildup of U.S. government debt could also lead to calls for the central bank to print more money to help pay it down sooner, which could also have long-term inflationary effects.
For the average American or Canadian middle-class household grappling with an era of high unemployment and stagnant wages, the prospect of rising prices over the next few years could amount to another body blow. Even a moderate rise in the rate of inflation would further squeeze workers’ paycheques as prices for everything from food and clothing to gasoline and home insurance climb. And good luck trying to negotiate corresponding wage increases with employers that are still nursing badly wounded balance sheets. At the same time, a rapid rise in interest rates to thwart inflation could derail the current recovery, sending people right back to the unemployment line.
You don’t need to reach as far back in history as Germany’s Weimar Republic to get a sense of the havoc unchecked inflation can wreak. In fact, you really only need to go back to the early 1980s in the U.S. and Canada. Following the oil shocks of the 1970s, both countries experienced soaring inflation that ultimately led to double-digit interest rates. While lawmakers had experimented with wage and price controls, serious efforts to combat inflation initially took a back seat to economic growth and employment—goals that are once again driving today’s rock-bottom interest rates.
Could it happen again? In January, Canada’s consumer price index rose to 1.9 per cent from 1.3 per cent a month earlier, the largest increase in more than a year. The index measures the change in prices of goods and services bought by households, including food, shelter, transportation, energy, and clothing and footwear, over a 12-month period. While a big chunk of the increase was due to rising gasoline prices, the Bank of Canada’s core measure of inflation, which strips out volatile items like food and energy prices, still managed to hit its official two per cent target almost a year and a half ahead of schedule. Meanwhile, wholesale prices in the U.S. were up 1.4 per cent, about double what had been forecast.
Despite the unexpected jump in core inflation, economists are nevertheless expressing confidence that pricing pressures will abate. Diana Petramala, an economist at TD Bank, wrote in a report that the increase is “rather surprising” during the early stages of an economic recovery, but noted that it’s being measured against the significant price declines experienced in January of last year. She argues that core inflation will likely drop to a rate of 1.6 per cent to 1.8 per cent for the remainder of the year.
The confidence stems from the belief that there are scores of idled factories and businesses running at partial capacity that can be ramped up to meet rising demand. “At the end of the day, the prevailing forces that would keep inflation pressures at bay would be the amount of excess capacity in the economy,” says Craig Wright, the chief economist at Royal Bank. “And with a high unemployment rate, you tend to see workers looking more for job security than wage gains, and that also tends to limit inflation.”
