Latest / How Canadian Markets Work / Episode 24: Inflation and the CPI (The Shared Basket Illusion)

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Episode 24: Inflation and the CPI (The Shared Basket Illusion) · How Canadian Markets Work

• 0:00
  So if I told you that the people in charge of
• 0:02
  our economy actively want your money to lose
• 0:06
  its value every single year. You'd probably think
• 0:09
  they were completely crazy. I mean, yeah, that
• 0:11
  sounds entirely backward, right? But you sent
• 0:14
  us this, honestly, this incredible stack of sources
• 0:17
  on the Bank of Canada. And I know you were wondering
• 0:19
  specifically why your grocery bills just keep
• 0:21
  going up and why the central bank seems, well,
• 0:24
  entirely okay with it. Yeah, it's such a natural
• 0:26
  question. Because when you look at inflation
• 0:28
  just stripping away your purchasing power month
• 0:30
  after month, the logical question is why doesn't
• 0:33
  the central bank just aim for exactly 0 % inflation?
• 0:37
  Why not just freeze prices right where they are?
• 0:39
  And that is the great paradox here. Yeah. prices
• 0:44
  not moving a single set from one year to the
• 0:46
  next is actually, it's a massive economic trap.
• 0:49
  Wait, really? A trap? Oh, absolutely. The central
• 0:52
  bank doesn't target zero. They deliberately target
• 0:54
  2 % inflation. They are actively managing the
• 0:57
  economy to make sure your money loses about 2
• 1:00
  % of its value annually. And understanding the
• 1:03
  mechanics behind that choice kind of changes
• 1:05
  everything about how you view the whole financial
• 1:07
  system. Well, that is exactly our mission for
• 1:10
  this deep dive. We're going to slowly unpack
• 1:12
  the core mandate of the Bank of Canada. We'll
• 1:15
  look at the joint framework they share with the
• 1:17
  federal government. break down the actual chain
• 1:20
  reactions that make 0 % inflation so dangerous.
• 1:24
  It's fascinating stuff. It really is. It sounds
• 1:27
  like pure, cold mathematics. But central banking
• 1:30
  is actually this wild mix of psychology, timing,
• 1:34
  and very carefully chosen words. But before we
• 1:37
  get into the map and why the destination is 2%,
• 1:39
  we kind of need to understand who is actually
• 1:41
  driving the car. Right, the bank itself. So they
• 1:44
  basically have four primary jobs. They issue
• 1:48
  our physical currency. They act as the fiscal
• 1:50
  agent for the federal government. Which means
• 1:52
  what, exactly? Basically, they manage the government's
• 1:55
  own bank accounts and handle the really complex
• 1:57
  auctions of national debt. Oh, okay. Yeah. And
• 2:01
  then their third job is promoting the stability
• 2:04
  of the broader financial system. But the fourth
• 2:07
  one, and this is the big one, is conducting monetary
• 2:10
  policy. The engine of the economy. Exactly. That
• 2:13
  last responsibility is the engine. And it operates
• 2:15
  under a very specific... arrangement called a
• 2:19
  joint inflation targeting framework. Right. And
• 2:21
  looking through the documents you sent over,
• 2:23
  the target is explicitly 2 percent, which sits
• 2:26
  right at the midpoint of a 1 to 3 percent control
• 2:28
  range. But what really stood out to me is that
• 2:31
  this target isn't just cooked up in a vacuum
• 2:33
  by, you know, some economists sitting in a basement.
• 2:37
  No, not at all. It's actually agreed upon jointly
• 2:39
  by the bank and the elected federal government.
• 2:42
  And they have to sit down and renew that specific
• 2:44
  agreement periodically, right? Yeah, they do.
• 2:47
  So the elected government and the bank, they
• 2:49
  agree on the destination together. But the arrangement
• 2:52
  that follows is what we call operational independence.
• 2:55
  Operational independence. Right. So the politicians
• 2:58
  define the end goal, the 2 % inflation. But the
• 3:02
  technocrats at the bank alone decide how and,
• 3:06
  you know, when to move the interest rate levers
• 3:08
  to actually get the economy there. Okay, I want
• 3:10
  to challenge that structure for just a second.
• 3:12
  Sure. Because if the government and the bank
• 3:14
  both agree that 2 % is the goal, why bother handing
• 3:17
  over the steering wheel at all? Like, why not
• 3:20
  just let the elected officials who are actually
• 3:22
  accountable to voters set the interest rates
• 3:25
  themselves? to hit that target? Well, to answer
• 3:27
  that, we kind of have to look at the historical
• 3:29
  track record. Like, what happens when politicians
• 3:32
  control the money supply? I'm guessing it doesn't
• 3:34
  go well. It rarely does. If an elected official
• 3:37
  has the power to set interest rates, they face
• 3:39
  this overwhelming structural temptation to artificially
• 3:44
  lower those rates right before an election. Oh,
• 3:46
  of course. To make everything look great. Exactly.
• 3:49
  You slash interest rates and borrowing becomes
• 3:51
  incredibly cheap. Businesses take out loans to
• 3:54
  expand. People take out these massive mortgages
• 3:56
  to buy homes. And the economy feels absolutely
• 3:59
  fantastic in the short term. The incumbent government
• 4:02
  looks like economic geniuses right as voters
• 4:05
  head to the polls. It's like a sugar rush. It
• 4:08
  creates this temporary illusion of wealth. But
• 4:11
  I'm guessing the hangover hits shortly after
• 4:13
  the ballots are counted. Oh, it hits hard. The
• 4:16
  mechanism always catches up with them. That artificial
• 4:18
  injection of cheap money means you suddenly have
• 4:21
  just too many dollars chasing the same amount
• 4:23
  of goods and services. Right. And the inevitable
• 4:25
  result of that is runaway inflation. So operational
• 4:28
  independence acts as this structural firewall.
• 4:31
  It separates the long -term health of the currency
• 4:34
  from the short -term survival incentives of the
• 4:36
  political cycle. The technocrats don't have to
• 4:38
  worry about winning an election next October.
• 4:40
  Exactly. They only have to worry about the math.
• 4:42
  Though there is a fail safe built into the system,
• 4:45
  I noticed under the Bank of Canada Act, the government
• 4:48
  technically has the power to issue a formal directive
• 4:51
  to the bank, like to force their hand in extraordinary
• 4:55
  circumstances. Yes, that provision does exist
• 4:58
  basically to ensure that ultimate democratic
• 5:00
  authority is preserved. Yeah. However, the mechanism
• 5:03
  is designed to be highly public, very formal
• 5:06
  and just immensely politically costly because
• 5:09
  of the optics. Exactly. If a government were
• 5:12
  to actually issue that directive, they would
• 5:14
  be signaling to global financial markets that
• 5:17
  they are overriding their independent central
• 5:19
  bank. The resulting panic from international
• 5:21
  investors who would immediately doubt the stability
• 5:24
  of the currency, it makes the process so toxic
• 5:27
  that no government has ever actually used it.
• 5:30
  Wow. OK, so the firewall holds. The bank gets
• 5:32
  to drive the car independently to keep politicians
• 5:35
  from crashing it. Beautifully put. But let's
• 5:37
  look at the map itself. Who decided 2 % was the
• 5:41
  safe destination? Why not aim for zero? When
• 5:45
  I was reading through the research you shared
• 5:46
  with us, I started thinking about this like driving
• 5:50
  on a really winding cliffside road. Oh, I like
• 5:53
  that analogy. You want to stay safe. Yeah. But
• 5:55
  you don't aim your right tires exactly on the
• 5:58
  jagged edge of the cliff, which would be perfect
• 6:01
  zero percent inflation. You leave a two foot
• 6:04
  buffer zone. Yes, because that cliff is deflation.
• 6:07
  If a central bank targets exactly 0%, the natural,
• 6:12
  completely unpredictable fluctuations of the
• 6:14
  global economy mean that half the time, the inflation
• 6:17
  rate will accidentally dip below zero. And you
• 6:19
  fall off the cliff. Exactly. You fall into deflation,
• 6:22
  where prices across the entire economy are actively
• 6:24
  dropping. Now, on the surface, falling prices
• 6:26
  sound fantastic. Like, to anyone walking to a
• 6:29
  store, that sounds great. But when you look at
• 6:30
  the Shane reaction, it's actually an economic
• 6:32
  nightmare. It truly is. Because if you know that
• 6:35
  a new car or a refrigerator or even a house is
• 6:37
  going to be 5 % cheaper next year, you wait.
• 6:40
  You just delay the purchase. Right. And when
• 6:43
  millions of consumers simultaneously decide to
• 6:45
  delay their purchases, aggregate demand just
• 6:48
  collapses. Businesses see their sales completely
• 6:51
  plummet. So what do they do? Well, to survive,
• 6:54
  they have to drop their prices even further just
• 6:56
  to entice buyers. Which, of course, just reinforces
• 6:59
  the consumers' belief that they should keep waiting.
• 7:02
  Oh, wow. It's a feedback loop. A terrible one.
• 7:05
  It triggers this massive downward spiral of frozen
• 7:07
  economic activity. The part that really illuminated
• 7:10
  the danger for me though is the debt dynamic.
• 7:13
  Because your physical assets might be getting
• 7:15
  cheaper, but your liabilities, they do not shrink.
• 7:18
  No, they don't. If you owe $100 ,000 on a mortgage
• 7:21
  or a business loan, that nominal number is etched
• 7:24
  in stone. But in a deflationary world, money
• 7:27
  itself is getting harder to come by. Wages are
• 7:30
  dropping, business revenues are shrinking, but
• 7:32
  the monthly loan payment stays exactly the same.
• 7:35
  Which means the real burden of that debt becomes
• 7:38
  heavier every single month. Defaults start to
• 7:41
  spike across the board. So you're absolutely
• 7:43
  right. That 2 % buffer keeps the economy safely
• 7:46
  away from the edge of that deflationary spiral.
• 7:49
  But beyond avoiding the cliff, there's a second
• 7:51
  reason for the 2 % target. And it's about giving
• 7:54
  the central bank actual ammunition to fight recessions.
• 7:57
  Room to cut. Exactly. Yeah. Central banks stimulate
• 8:01
  a struggling economy by cutting interest rates.
• 8:03
  Right. Well, if the normal target for inflation
• 8:06
  is two percent, then normal interest rates will
• 8:09
  sit comfortably above that, maybe around four
• 8:12
  or five percent. OK. When a crisis hits, the
• 8:15
  bank has four or five percentage points of room
• 8:17
  to cut rates, which makes borrowing cheaper and
• 8:19
  restarts the economic engine. But if they targeted
• 8:22
  zero inflation, normal interest rates would sit
• 8:25
  very close to zero all the time. So when a recession
• 8:27
  hits, they're already at the floor. Precisely.
• 8:30
  They have no conventional levers left to pull.
• 8:32
  They need a running start and that 2 % baseline
• 8:34
  gives them the runway. It really does. And then
• 8:37
  the third reason, which I found completely rooted
• 8:39
  in psychology, is wage rigidity. It's so fascinating.
• 8:44
  Yeah, human beings are just deeply, deeply attached
• 8:46
  to the nominal number on their paycheck. Like
• 8:49
  if a company falls on hard times and needs to
• 8:51
  reduce its labor costs by 5 % just to avoid bankruptcy,
• 8:55
  the purely mathematical solution is to give everyone
• 8:58
  a 5 % pay cut. But in reality you can't do that.
• 9:02
  Cutting nominal wages destroys morale. People
• 9:04
  actively revolt or they just quit. Employers
• 9:07
  know this. So instead of cutting everyone's pay
• 9:09
  by five percent, they're practically forced to
• 9:12
  simply fire five percent of their workforce.
• 9:15
  Mass layoffs. But inflation acts as this silent
• 9:17
  lubricant in the labor market with a background
• 9:19
  inflation rate of two percent. An employer who's
• 9:22
  struggling through a tough year doesn't have
• 9:24
  to cut anyone's actual paycheck. They just hold
• 9:26
  everyone's wages flat. Yes. The nominal number
• 9:29
  stays exactly the same. So the psychological
• 9:31
  blow is completely avoided. But because inflation
• 9:34
  is slowly eroding purchasing power by 2%, the
• 9:37
  company's real labor costs are gently adjusting
• 9:39
  downward. It's like an invisible adjustment mechanism.
• 9:42
  It preserves jobs during economic downturns simply
• 9:46
  because humans will accept a frozen paycheck
• 9:48
  way more readily than a shrinking one. It's all
• 9:51
  psychology. Now the fourth reason is purely mathematical.
• 9:54
  It comes down to a flaw in how we actually measure
• 9:57
  inflation in the first place. The consumer price
• 10:00
  index, the CPI, has a natural measurement bias.
• 10:03
  Right, because the CPI tracks a fixed basket
• 10:06
  of goods. Exactly. But it really struggles to
• 10:09
  perfectly account for the substitution effect
• 10:11
  in real time. Like, if the price of beef skyrockets,
• 10:15
  consumers quietly substitute it by buying more
• 10:17
  chicken instead. Oh, I see. But the CPI might
• 10:20
  still be heavily waiting that expensive beef,
• 10:22
  which overstates the actual inflation the consumer
• 10:25
  is experiencing. And it also struggles with quality
• 10:27
  changes, right? Like a smartphone today might
• 10:30
  cost more than a basic cell phone 10 years ago,
• 10:32
  but it is effectively a supercomputer. That's
• 10:35
  a perfect example. The price went up, but the
• 10:38
  intrinsic value went up exponentially more. So
• 10:40
  because the index naturally runs just a little
• 10:43
  bit hot due to those biases aiming for a measured
• 10:46
  2 percent means that true underlying inflation
• 10:50
  is actually hovering much closer to genuine price
• 10:53
  stability. OK, so we have the deflation buffer,
• 10:56
  the room to cut, the wage lubricant, and the
• 10:59
  measurement bias. That clearly tells us why the
• 11:02
  map says 2%. But how do the actual people inside
• 11:05
  the bank steer the ship into that harbor? Well,
• 11:09
  decisions at the Bank of Canada are made by the
• 11:11
  governing council. which is chaired by the governor,
• 11:13
  and they operate under a strict consensus model.
• 11:16
  Which is different from other central banks.
• 11:17
  Very different. If you watch the United States
• 11:19
  Federal Reserve, for example, you'll often see
• 11:21
  recorded votes, public dissent, internal factions
• 11:23
  arguing over the direction of interest rates.
• 11:26
  The Bank of Canada approaches it entirely differently.
• 11:29
  They debate vigorously behind closed doors, but
• 11:32
  they emerge with a single unified consensus position.
• 11:35
  There's such a heavy psychological weight to
• 11:37
  a unified front like that, and they deliver that
• 11:40
  consensus on a very strict schedule too, the
• 11:42
  fixed announcement dates. Yeah, the bank publishes
• 11:45
  a schedule months in advance detailing the exact
• 11:48
  eight days a year they will announce their interest
• 11:50
  rate decisions. And that matters because... Well...
• 11:54
  Historically, central banks could just change
• 11:57
  rates on a random Tuesday, which kept financial
• 12:00
  markets in this constant state of anxiety and
• 12:03
  fueled endless rumor and speculation. Right.
• 12:05
  Nobody wants surprises with their money. Exactly.
• 12:09
  The fixed schedule removes that volatility. It
• 12:12
  forces the market to focus on the underlying
• 12:14
  economic data rather than constantly guessing
• 12:17
  when the central bank might suddenly intervene.
• 12:19
  You know, as I looked at the monetary policy
• 12:22
  reports and the transcripts of the speeches they
• 12:24
  give on those fixed dates, I realized something
• 12:26
  profound about their strategy. They aren't just
• 12:28
  stepping up to a podium to explain a mathematical
• 12:30
  policy to the public. No they aren't. The talking
• 12:33
  actually is the policy. It feels like an incredibly
• 12:35
  high -stakes mind game. It absolutely is a mind
• 12:39
  game. Forward guidance is arguably their most
• 12:42
  effective mechanism. Managing the public's expectations
• 12:45
  of future inflation physically alters how inflation
• 12:48
  behaves in the present. Let's gently unpack the
• 12:52
  mechanics of that mind game for you listening.
• 12:54
  If the governing council stands at a podium and
• 12:57
  credibly convinces the public that they will
• 12:59
  absolutely bring inflation back down to 2%, it
• 13:02
  changes our behavior today. Completely. If I
• 13:05
  believe inflation is going back down, I don't
• 13:07
  go to my boss and demand a 10 % raise to cover
• 13:09
  my future costs. If businesses believe inflation
• 13:12
  is dropping, they don't aggressively hike the
• 13:15
  prices of their products in a panic. just to
• 13:18
  stay ahead of the curve. And by altering that
• 13:20
  expectation, the wage price spiral is neutralized.
• 13:23
  Because the public acts calmly, inflation naturally
• 13:26
  moderates. The expectation creates a literal
• 13:30
  self -fulfilling prophecy. That's incredible.
• 13:32
  The credibility of the central bank's voice does
• 13:34
  the heavy lifting for them, meaning they don't
• 13:36
  have to raise interest rates nearly as high to
• 13:39
  achieve the exact same cooling effect on the
• 13:41
  economy. But even with operational independence,
• 13:44
  a 2 % buffer and the power to shape expectations,
• 13:49
  steering the economy has to be remarkably difficult
• 13:52
  because they are operating under immense limitations,
• 13:56
  primarily this thing called the policy lag. Yes,
• 13:59
  the lag is brutal. When the governing council
• 14:01
  decides to change the interest rate today, the
• 14:04
  maximum impact of that decision won't be felt
• 14:06
  in the real economy for roughly 18 months to
• 14:09
  two years. I was thinking about it like a doctor
• 14:11
  prescribing blood pressure medicine, but the
• 14:13
  pill takes two years to actually dissolve in
• 14:16
  your stomach. That is, wow. Yeah, that's exactly
• 14:18
  what it's like. They're setting policy today
• 14:20
  based on economic conditions they cannot actually
• 14:22
  see yet. Right. And the mechanism of that delay
• 14:25
  is just built right into the structure of the
• 14:27
  financial system. Think of the mortgage market.
• 14:29
  If the bank raises rates today, A homeowner who's
• 14:32
  locked into a five -year fixed mortgage feels
• 14:35
  absolutely no change in their monthly expenses
• 14:37
  tomorrow. They just keep spending normally. Exactly.
• 14:40
  It is only years later when that mortgage finally
• 14:43
  comes up for renewal at the new higher rate that
• 14:46
  the household suddenly has thousands of dollars
• 14:49
  less in disposable income. The same applies to
• 14:52
  massive corporate loans financing multi -year
• 14:55
  factory bills. The repricing is just agonizingly
• 14:59
  slow. And on top of that two -year delay, the
• 15:02
  instrument itself is incredibly blunt. They only
• 15:04
  have one policy interest rate for the entire
• 15:07
  country. Going back to the doctor analogy, it's
• 15:09
  like prescribing the exact same dose of that
• 15:11
  blood pressure medicine to a 250 -pound bodybuilder
• 15:15
  and a 90 -pound grandmother simply because they
• 15:17
  live in the same house. The regional disparities
• 15:20
  in a country like Canada make this a constant,
• 15:22
  massive challenge. You can have a province experiencing
• 15:25
  an absolute economic boom driven by global oil
• 15:28
  prices, right? Where localized inflation is running
• 15:30
  incredibly hot. But simultaneously, another province
• 15:34
  could be deep in a manufacturing recession, shedding
• 15:36
  jobs and desperate for stimulus. The central
• 15:39
  bank cannot isolate its policy. It has to apply
• 15:42
  the exact same interest rate to the booming province
• 15:44
  and the struggling province at the exact same
• 15:46
  time. It's important to note the scope of their
• 15:48
  mandate when they wield that blunt instrument
• 15:50
  too, because the Canadian framework is traditionally
• 15:53
  centered squarely on inflation. This is a sharp
• 15:57
  contrast to the U .S. Federal Reserve, which
• 15:59
  operates under an explicit dual mandate. Right.
• 16:02
  The Fed is legally required to balance inflation
• 16:05
  control with maximum employment. Now, recent
• 16:08
  renewals of the Canadian agreement have introduced
• 16:10
  some language about taking labor market considerations
• 16:12
  into account, but inflation really remains the
• 16:15
  primary overriding anchor. It does. And the application
• 16:19
  of that interest rate tool brings us to the distributional
• 16:22
  effects. Adjusting the cost of money is not a
• 16:25
  neutral action. It mechanically transfers wealth
• 16:28
  and burden between different groups of people
• 16:31
  in society. We should be really clear here and
• 16:33
  walk through exactly how those mechanical shifts
• 16:35
  happen just looking at the facts. When the bank
• 16:37
  lowers interest rates, borrowing becomes incredibly
• 16:40
  cheap. The immediate winners are borrowers, anyone
• 16:43
  taking out a mortgage or a business loan. But
• 16:45
  it also creates a massive windfall for asset
• 16:47
  owners. Because of leverage. When debt is virtually
• 16:51
  free, investors can take out massive loans to
• 16:54
  bid up the prices of real estate and stocks.
• 16:57
  The demand fueled by cheap borrowing inflates
• 16:59
  the value of the assets. Conversely, the mechanical
• 17:03
  losers in a low -rate environment are savers.
• 17:06
  Right. Retirees who rely on the safe yield from
• 17:08
  bonds or savings accounts, they just see their
• 17:11
  passive income evaporate. But when inflation
• 17:13
  forces the bank to aggressively raise rates,
• 17:16
  that entire mechanical reality violently reverses.
• 17:19
  Savers are suddenly rewarded with substantial
• 17:21
  returns on their deposits. But borrowers are
• 17:24
  crushed. The carrying cost of variable rate mortgages
• 17:27
  and lines of credit skyrockets, which just drains
• 17:30
  disposable income. And the higher rates actively
• 17:32
  depress asset prices, too. Exactly. Because the
• 17:35
  chief leverage disappears, the demand for housing
• 17:38
  and equities evaporates, pulling the valuations
• 17:40
  back down to Earth. Every single time the central
• 17:43
  bank moves the lever, it is reallocating capital
• 17:45
  between savers and borrowers, between asset owners
• 17:48
  and wage earners. It just really highlights the
• 17:51
  massive responsibility placed on the governing
• 17:53
  council. Let's pull all these threads together
• 17:56
  for you. We've explored the operational independence
• 17:59
  of the bank, how the elected government sets
• 18:01
  the destination, but the technocrats steer the
• 18:04
  ship to avoid the temptation of cheap pre -election
• 18:07
  money. how it provides a vital buffer against
• 18:12
  the downward spiral of deflation, ensures the
• 18:15
  bank has room to cut rates in a crisis, serves
• 18:18
  as a silent lubricant for rigid human wages,
• 18:21
  and compensates for the natural measurement biases
• 18:24
  in tracking inflation. Right. We looked at the
• 18:26
  machinery of consensus on fixed announcement
• 18:28
  dates and how forward guidance transforms the
• 18:31
  bank's communication into a literal policy tool
• 18:33
  designed to shape public behavior. And finally,
• 18:37
  we looked at the sheer difficulty of the job.
• 18:39
  trying to balance the wealth transfers of a massive
• 18:42
  economy using a single blunt interest rate while
• 18:45
  waiting up to two years for the plumbing to actually
• 18:47
  deliver the water. The entire architecture of
• 18:50
  the system is elegant, but it rests entirely
• 18:52
  on a foundation of public credibility. Which
• 18:54
  leaves me with a final thought for you to turn
• 18:56
  over in your mind. We established that managing
• 18:59
  expectations is the most powerful tool the central
• 19:02
  bank has to stop a wage price spiral. But what
• 19:06
  happens to an economy if the public simply stops
• 19:09
  believing the central bank's forecasts? That's
• 19:12
  the big question. If talking is truly the mechanism
• 19:14
  that makes the math work, does the entire structure
• 19:17
  of modern monetary policy just break down the
• 19:20
  moment a central bank loses the public's trust?
• 19:23
  Honestly, if the public decides the central bank's
• 19:26
  words carry no weight, the mathematical tools
• 19:28
  alone might not be powerful enough to regain
• 19:30
  control. Thank you so much for bringing this
• 19:32
  stack of research to us and for joining us on
• 19:35
  this deep dive. Keep picturing that cliffside
• 19:37
  road and we hope you have a wonderful rest of
• 19:39
  your day.