With this month’s announced change in the Bank of Canada’s monetary policy objectives, it has now joined other central banks around the world in having a mandate that is conflicted and, will at some point, become impossible to achieve. The previous mandate was unequivocal in that the Bank of Canada’s job was to maintain inflation in a range of 1% to 3%. This very clear mandate has now been blurred by the addition of the further task of maintaining employment levels. The timing of this change is prescient, for it comes at a time when inflation is rising and, by rights, the Bank of Canada should be raising interest rates to combat it. Although the new mandate clearly indicates that managing inflation remains the priority, the dual mandate will likely create ambiguity, introducing a new uncertainty into monetary policy.
The Federal Reserve Board in the U.S. introduced the dual target in 1987. Since then, central banks around the world have enacted similar policies. At first, this shift seemed benign, but since the onset of the Great Financial Crisis, this has led to a major increase in money supply and an associated increase in the size of Central Banks balance sheets.
The deflationary fears of the last decade encouraged central banks to increase the growth in the money supply (M-3 in the chart below). However, without a corresponding increase in the size of the economy, this essentially dilutes the value of a dollar, as there is more money chasing the same assets. This benign inflation environment also allowed central banks to focus more on avoiding a weak economy and the subsequent rise in unemployment than in fighting inflation, which they currently only reluctantly admit could be a problem.
With that, we need to clearly understand why inflation can become a problem. Not only does the cost-of-living increase once inflation takes hold, but it also destroys the value of one’s assets. Consumer Price Index (CPI), the most commonly quoted inflation number, focuses on the cost of a specifically constructed basket of goods, but essentially ignores the increase in asset prices. Therein lies the concern of many, that the CPI is not reflective of the actual destructive value of inflation. Think of this in terms of a rental property, where the price of the property rises but the income generated by it does not. This is asset price inflation without an associated increase in the cost of living and can create an unintentional redistribution of wealth and income.
Over the last decade, the Central Banks’ policies of increasing money supply and holding interest rates artificially low, has created this situation. Older members of society who expected to live off their savings, have seen those savings debased by the collapse in interest rates to near zero. This has forced many retirees to invest in more volatile assets that offer a higher potential return. Similarly, younger generations who are seeking to acquire assets, find the cost of entry beyond their reach. In other words, some people have assets, but no income and others can generate income but cannot build assets.
Source: http://www.stern.nyu.edu/~adamodar/New_Home_Page/data.html
Linking this back to financial markets, as can be seen in the chart above, during the inflationary period in the 1970’s and early 1980’s, only gold clearly outperformed the impact of both the increase in money supply and CPI inflation. With the surge in money supply that began in 2010, it once again became more challenging for some asset classes to create sufficient value to outweigh this dilutive impact.
In the chart below, you can see that as central banks once again opened the spigot in 2020, only the change in equity prices exceeded the growth in money supply, while other asset classes generated returns barely above the inflation level.
Source: https://fred.stlouisfed.org/series/DGS10/
With central banks now getting the inflation that these policies were designed to create, the question for investors is if and how these policies will be unwound. While the Bank of Canada held only one mandate surrounding inflation, the expectations were clear. With the addition of a second mandate, investors must assess how determined the Bank of Canada will be in fighting inflation if employment remains below targeted levels. Only time will give us an answer.
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