As the COVID recession winds down, the tab comes due for the eye-popping public spending of the past year. One of those payments is the inflation tax, which is already a reality in the United States. With Wednesday’s news that Canada’s year-over-year inflation rate is 3.4 per cent, we aren’t far behind.
In April, the U.S. consumer price index rose by 0.8 per cent on a seasonally adjusted basis. That’s almost 10 per cent annualized. April may well be an aberration so let’s look at the last four months. With the U.S. rolling out its vaccination program and lifting many health restrictions, its CPI rose 0.3 per cent in January, 0.4 per cent in February and 0.6 per cent in March. Add in April and the overall CPI increase is 2.2 per cent in just four months. That’s an annualized six and half per cent.
On the other hand, at the end of April the U.S. year-over-year inflation rate was just 4.2 per cent – more than in Canada but less than 6.5 per cent. This lower rate includes the pandemic months last spring, however, when prices fell sharply for some critical goods, especially energy and housing. Even taking into account this catch-up effect, the trend is up in 2021 and at far more than the two per cent annual rate that monetary authorities would like to see.
The Federal Reserve Board is willing to tolerate a surge in prices so long as inflation eventually moderates – though how long moderation takes is an open question. A common view is that it will kick in as the US$1.9-trillion Biden stimulus dissipates and supply catches up to overheated consumer and public demand. So far, the market seems to believe that. The 10-year Treasury inflation-protected bond rate suggests that investors expect inflation to be 2.52 per cent annually.
Like a wealth tax, the inflation tax is also hurting savers by reducing the purchasing power of money
But even if inflation is only temporary, Americans will already have been hit hard by the inflation tax. Why? Prices have ratcheted up for many goods and services. Unless there is a recession, we can’t assume they will return to where they were. Thus, there has been a permanent reduction in purchasing power even if the inflation tax does prove to be “temporary.”
If current trends continue for the rest of the year, 2021 inflation could hit 6.6 per cent. For an American earning the average per capita income of US$60,000, that is equivalent to a tax hike of US$3,715 this year alone. And it repeats: if prices don’t fall back down, the reduction in purchasing power is permanent.
Like a wealth tax, the inflation tax is also hurting savers by reducing the purchasing power of money. As of May 19, the 10-year U.S. government bond rate was trading at 1.62 per cent. Anyone paying income tax at a marginal rate of 30 per cent would net only 1.13 per cent annually on an after-tax basis. Subtract the annualized 2021 inflation rate, and investors make a real return of minus 5.5 per cent. Desperately seeking yield, investors have already switched funds to riskier assets, including real estate and commodities.
Americans can recoup their losses from the inflation tax so long as they are awarded with more income. In a sense, they already have been. Despite the COVID recession, average nominal per capita household income rose by $3,255 in 2020, a bit less than the inflation tax. If labour seeks higher wages to make up for inflation, businesses will have little choice but to raise prices. With accommodative monetary policy focusing on full employment, inflation could take many years to disappear, with the result that inflation expectations lock in at much higher levels. Either that or the Fed becomes worried enough about inflation to raise interest rates and take the wind out of the economy’s sails.
Once health restrictions are lifted, expect Canada’s prices to jump. Will that be temporary or longer-lasting? The Bank of Canada has already indicated it might have to wind down quantitative easing sooner than initially projected. This has helped push the dollar up – that and surging commodity prices. A higher Canadian dollar does reduce inflationary pressures, although it makes our export industries less competitive.
Inflation reflects demand outstripping supply. The pandemic has created a supply shock with disrupted supply chains for goods ranging from semiconductors to lumber and copper. Many Canadian businesses are facing rising wages as workers either have retired from the work force (in part due to generous public benefits) or need retraining since their job won’t be coming back. Another $100 billion in federal stimulus demand, piled onto a $350-billion deficit for 2020, is stoking demand ever further, with more social spending coming.
The inflation tax is back. Americans have been hit first but we’ll be feeling it soon, too.