The Spectre Of Deflation Haunts The Bank Of Canada

Central bankers have long been charged with the responsibility of price stability. After about a decade of policy moves aimed at reaching widely-agreed upon inflation targets, bankers now fear that these targets are no longer attainable. In an extraordinary opening statement by Governor Poloz, the Bank expressed its fears of deflation. Right from the onset, the Bank opening remarks stress the importance of inflation targets and why the failure to reach these targets have serious consequences, to wit:

…. If inflation were to fall short of target for an extended period, faith in that anchor would be eroded, and policy-makers would face even greater challenges in returning the economy to full capacity. This challenge can become particularly acute should inflation fall persistently below zero. Sub-zero inflation, or deflation, would interact with existing indebtedness in a particularly undesirable way. Specifically, negative inflation would increase the real value of outstanding debts while it would erode the ability of companies and households to service their debt—a very difficult mix for the financial system…

The statement continues to argue that the risk of sustained deflation in Canada is quite low for three reasons. First, the bank maintains that the Federal government's actions to provide wage subsidies will boost confidence and contribute to a broad-based recovery. Second, Canada began the pandemic operating near potential and inflation around its 2 percent target. It anticipates that the economy will likely recover quickly from a major negative shock. Third, Canada has enjoyed considerable success in keeping inflation close to target for more than 25 years. This is a highly optimistic statement, implying, once the all-clear signal is given for Canadians to go back to work, the recovery will result in reaching inflation targets as the economy operates at potential.

However, the economy is seriously threatened owing to:

• The collapse in oil prices placing tremendous stress on the ability of Alberta’s and Newfoundland’s provincial budgets, the latter facing the prospects of a federal bailout;
• All provincial governments facing serious budget deficits resulting from extraordinary additional health care costs and the loss of tax revenues in general;
• Unemployment exceeding 20% of the workforce, as there are limits to how many jobs and workers can be maintained working from home;
• The plausibility of GDP falling by as much as 30% in the first half of 2020;
• Financial institutions operating under considerable stress; in the short run, the borrowing needs of government and the private sector are stretched to their limits; and longer-term borrowing costs remain elevated despite 150 bps cut in the Bank’s policy; and,
• Dysfunctional credit markets; the Bank decided to increase its participation in government treasury auctions and the purchase of existing debt instruments at the Federal and provincial levels; the Bank has already purchased assets amounting to 10% of Canada’s GDP in support of improving liquidity in major fixed income markets.

Given the above, it's hard to sustain optimism that Canada needs not experience deflation. The loss of jobs and business capital investment, alone, will result in prices falling as individuals and business search for a sense of normalcy. There is a growing consensus the recovery process will be slow and very muted, certainly not the V-shaped turnaround Bay Street would like to see. Deflation will define the economy for a considerable time.