While the market may be worried about rising inflation, a new paper from the Bank of Canada explains that allowing inflation to run hot in the wake of a severe downturn can have important economic benefits — particularly for hard-hit workers.
Following a severe downturn that pushed interest rates as low as they could go, “temporarily overshooting inflation” may support a faster recovery and a better balance between stable inflation and full employment, said a research note from the central bank’s economic analysis and financial research departments.
This approach could particularly benefit “vulnerable segments of the population, such as workers with low attachment to the labour force and the long-term unemployed,” the note said.
The labour market fallout from the Covid-19 pandemic has been “highly uneven,” with workers at the bottom end of the income distribution suffering “the most severe and persistent employment losses, while workers in the top income quartile face negligible losses,” the paper said
Younger workers and women in particular have been hard hit by the pandemic. This, in turn, has hurt the labour force participation rate and produced an “unprecedented rise in the long-term unemployment rate.”
Given the highly unequal economic effects of the pandemic, economic models indicate that tolerating higher inflation while keeping rates low can help harder-hit workers with reduced borrowing costs and lower interest payments that enable “increased consumption among constrained or high-debt households,” the paper said.
Under one model, “the additional spending by consumers who are more sensitive to the interest rate raises the incomes of hand-to-mouth consumers and prevents sharper and self-reinforcing reductions in spending and employment,” the paper noted.
The models also suggest that overshooting inflation can benefit households that experience long-term unemployment, the paper noted.
“We find that the optimal policy implied by the model that distinguishes between short- and long-term unemployment prescribes an overshoot of inflation for several quarters,” the paper said.
That being said, the paper acknowledged that allowing inflation to overshoot comes with challenges, such as financial stability risks that might emerge “due to prolonged periods of low borrowing costs.”
Additionally, the paper allowed that monetary policy is a relatively blunt tool for dealing with the unequal effects of a negative economic shock, such as a pandemic, “suggesting a role for more targeted fiscal policy to improve welfare.”