How fighting today’s inflation might increase tomorrow’s inflation

CalendarDecember 1, 2023

Only One Tool in the Kit: How fighting today’s inflation might increase tomorrow’s inflation

Inflation has been top of mind for businesses and consumers alike since the end of the pandemic. Bankers, economists, and businesses may have differing views on the causes and effects of inflation: higher demand; consumer spending; and competition for limited resources come to mind.

Despite the centrality of monetary policy to the smooth running of global economies, Central Banks have a limited number of tools in the kit. Conventional wisdom says that raising interest rates helps to temper inflation and ‘cool down’ an overheated economy; in times of downturn, increasing money supply helps to stimulate a sluggish economy.

While this toolkit may be highly effective in ‘normal’ circumstances, it may be less effective in other conditions. Unintended consequences could include higher inflation later in the cycle.

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Economics is called the ‘dismal science’ in part because of its focus on the management of scarcity. Analyzing trade-offs and available incentives when resources are limited is a challenge that humans have been grappling with for millennia.

This scarcity is likely top of mind for central bankers in the United States and Canada facing the latest round of higher-than-target inflation. Fiat currencies like USD and CAD have recently been declining in value (in terms of what goods & services they can buy) faster than their central banks’ can reach their annual targets of 2% inflation. In fact, scarcity pervades causes of inflation, and also the tools typically used to deal with it.

Interest Rates – The main tool used by the Federal Reserve and the Bank of Canada

In developed economies central banks are primarily tasked with maintaining price stability (though at times central bankers are also tasked with competing concepts, like ‘full employment’ or a ‘climate’ agenda). Monetary policy is the main tool available to help them achieve this task. Though limited, in normal circumstances it has arguably been mostly sufficient over the last few decades to moderate demand and abate inflationary pressures in the late stages of the business cycle. The problem is that we are not in normal circumstances.

The latest round of inflationary pressure has some similarities to the 1970s inflation shock in North America. Commonly cited causes for this latest round include supply shocks and disruption in the availability of goods and services – as well as the huge increase in spending by many governments during and after the COVID pandemic, which increased government debt and money supply. Aggregate demand in the economies of the US and Canada is largely on trend with pre-covid averages. What’s changed? Changes include massive disruption to our highly complex and integrated global economy – and the noted uptick in deficit spending. Increasing interest rates and making it more difficult to access capital might not solve this, though. It might make many poorer – and it might even plant the seed for more inflation in the future.

Following are point-in-time inflation trackers for Canada and the United States, focusing on increases in Shelter costs as a Consumer Price Index driver.

The reality of higher interest rates for consumers

Higher interest rates make borrowing money more expensive which can lead to less spending. A recent spending decrease is the dramatic decline in housing starts in the United States and Canada which largely correlated with the start of central banks in both countries’ interest rate hiking cycles (though other factors may also contribute). Housing, like other capital-heavy investments, involves long timelines and is largely financed via debt by market participants forecasting demand into an uncertain future.

While interest rate increases are not the sole reason for structural underinvestment in new housing units, it likely doesn’t help that funding costs have increased 250bps in the last 18 months. In fact, speaking to developers based on Canada’s west coast, most multifamily developments in British Columbia simply don’t pencil with construction lending at current rates.

Following are illustrations of the trends in housing starts for Canada and the United States.

While the housing sector is simply one illustration of a tradeoff of how higher rates to combat inflation can arguably contribute to future scarcity, it’s not the only sector impacted. As monetary policy is mediated through access to capital, the impact on future capacity is likely broad-based. Since central bankers are only able to address the demand side of the inflation equation, they might be planting the seeds of future inflation.

Would you like to discuss this further? Let’s schedule a chat about how inflation rates might be affecting your business, and potential approaches to help your business thrive in the current climate—and in the future!

Please note: Opinions expressed in this article are those of the author. Please contact an independent advisor to ensure that solutions discussed here are right for your business.

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Sean Coakley, CFA

Sean Coakley, CFA

Director, Strategic Sales, & Market Strategist

Sean works with mid-market corporates, focusing on FX risk management and international working capital optimization. He blends experience in finance and capital markets with a robust understanding of business performance and capital markets knowledge.