Inflation vs stagflation?

Ashleay: Welcome to the IN YOUR INTEREST! podcast from iA Financial Group, where we discuss your need-to-know economic news and how it affects your finances. All this in under 10 minutes. The topic of the day - inflation. Why are we talking about it so much? My name is Ashleay. My colleague, Sébastien Mc Mahon, Chief Strategist and Senior Economist, is here to answer this question. Hi, Sébastien.

Sébastien: Hey, Ashleay.

Ashleay: So why is inflation such a hot topic? I mean, some say we're overreacting. Do we really need to do anything?

Sébastien: Well, inflation is a really hot topic because in 2022, we're seeing inflation at 6.8% early in the year in Canada, over 8% in the US. So, we haven't seen these levels since the early 1990s. So, it's been over 30 years since we've seen that. So that's why it's a hot topic. So maybe just a quick history lesson here on inflation: so maybe those that will be listening to us here today don't remember, but in the 1970s, inflation started to happen quite dramatically when the OPEC countries, so the oil producing countries, realized that, hey, maybe we could cut the production here, push prices higher and make more profit. And since the price of oil or gasoline is such an essential part of the financial system, the economic system, well, it led to inflation that lingered on for many years. And then if we move all the way to the 1980s, inflation was so entrenched that inflation expectations became very, very elevated. And when I say that, it’s that households were expecting inflation to remain at 8, 10, 12%, businesses the same thing. So, everyone started signing, you know, work contracts with clauses that the wages should rise by 8, 10, 12% for a while to compensate for inflation. The suppliers of goods for stores the same thing - signing clauses that they need to be compensated for inflation 8, 10, 12%. And then you get kind of a self-fulfilling prophecy. So, inflation remains high because everyone is expecting it and they're signing contracts that have these clauses embedded in them. So, inflation became kind of the economic enemy number one in the 1980s, and everyone realized that it needed to be tamed. So because, there are a few reasons, so inflation, first - it destroys the purchasing power of those that are less fortunate. So, it's not everyone that has their wages adjusted for the rate of inflation when inflation is 10, 12%. So, there is a real loss of purchasing power. For companies, input prices are rising. So, if a store sells you something but the price of the goods that they buy, they rise at different paces, different prices. Sometimes that's going to hurt their profit margin. And also, very importantly, inflation tends to push interest rates higher, which creates a constant brake on growth. So, central banks are there to make sure that inflation now is at a low level. In the 1980s, that was not the case. So, now the world we live in is a bit different. But seeing inflation at the levels of the early 1990s, it spooked a few players, let's say.

Ashleay: Right. And you touched on central banks. Can you explain what they are?

Sébastien: Yeah, sure. So, to try to make this easy: so central banks are entities, their role, so they're governmental entities: in Canada, we have the Bank of Canada; in the US, there is the Federal Reserve; in Europe, there's the European Central Bank. So, their role is that they need to keep inflation at a low but stable level and how they do that, there's many things that they can do, but let's concentrate on the leading rate, so, the short-term interest rate. This is the rate that filters through your mortgage if you have a variable mortgage. So, the preferential rate that you have at your financial institution is linked to the leading rate. Same thing if you have revolving credit at your financial institution, the rate that you'll be paying is floating, and it's based on that. So, the idea is that central banks, they look at inflation, they look at the economy. And when they see the economy getting too hot and inflation getting too high, they will raise the leading rate to calm the economy down. And when they see the economy slowing down too much, they will lower the leading rate just so that it's easier to get access to credit. You pay less interest, so it just kickstarts the economy.

Ashleay: Right. Okay, perfect. And if we come back to inflation, is it simply a question of leveling?

Sébastien: No, it's not just the level of inflation that's important. It's also the volatility of inflation. So, let's say inflation fluctuates between 2% and 10% for a few years. It becomes then very, very difficult for businesses and for households to plan ahead. Everyone wants to have stable inflation just so that you can better plan and you can take better business and personal decisions. So, that's one thing. Maybe counterintuitively, but the worst thing that you could see, even worse than high and fluctuating inflation, is deflation, which means negative inflation, so the prices are going down every single year. And we've seen that for most of the last 30 years in Japan. We've seen deflation over there. And this is really a strong headwind on growth because when you have deflation, you have consumers, you have businesses waiting to commit to buying products, buying commodities because you're expecting to pay less next year and even less after that. So, it hurts economic growth. So, negative inflation is worse than volatile inflation.

Ashleay: Right, exactly. Because if I wait before purchasing something, it'll always delay my decision and then the economy won't grow, basically.

Sébastien: Yeah, exactly.

Ashleay: Right. And so, we hear often about stagflation. Could you tell me a bit more about what that means?

Sébastien: Yeah, stagflation. It's a term that originated in the 1970s. And the definition is: when inflation becomes high enough that it starts to eat into economic growth. So, stagnation of the economy plus inflation, you get stagflation. So, this is a bit what we're starting to see in 2022. We're seeing inflation being high. We see inflation concentrated in the price of food and the price of gasoline and energy. So that means that when you go to the grocery store, you buy the same thing that you typically buy, but you pay more for them. When you go put gas in your car, you put the same quantity of gas in the car, but you pay more. So that means that you have less money at the end of the week to buy anything else. So that means the economy slows down and that's what gets you. That's what's defined as stagflation.

Ashleay: Right. Okay. And so, to wrap up, which would be better?

Sébastien: History tells us that positive but stable and low inflation is best. So many works have been done by central banks around the world. And the conclusion is that pretty much everywhere, a target range of 1 to 3% is best, with a middle point of 2%. So, you want to have inflation that's predictable to allow for sound business decisions. You want it to be positive so that not everyone is there waiting for next year to purchase stuff. So that means you have some economic growth, but you want it to be stable. So central banks, that's their role.

Ashleay: Great. Well, thank you very much for this interesting podcast and we'll see you soon.

Sébastien: Sure. Thank you, Ashley.

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