Earlier this month, while analyzing Canada’s macroeconomic data, I observed a significant trend: the monetary aggregate M1+, which measures the money stock in circulation, had surged by more than 33% since the onset of the COVID-19 pandemic. M1+ comprises all currency outside of banks plus balances held in chequing accounts, and it is usually used to measure the money supply in a national economy. This revelation led me to realize that this surge likely provides a better understanding of the high inflation we discussed in our previous blog, as well as the increased price levels and concerns surrounding the housing market.
Several factors have driven Canada’s money supply to grow at the fastest rate, resulting in Canadians holding a record amount of cash. In response to the COVID-19 pandemic, the Canadian government acted swiftly, not only ensuring widespread access to vaccines, tests, treatments, and personal protective equipment, but also providing various benefits to offer temporary income support to individuals and employers. Up until the end of 2022, the Canadian government had disbursed over 200 billion Canadian dollars. This substantial financial aid prevented a rise in poverty, mitigated income inequalities, and facilitated the country’s economic recovery from the pandemic’s adverse effects. However, this cash flowed into the market and a significant portion remained saved up in the pockets of residents due to COVID restrictions.
Simultaneously, the Bank of Canada took measures to stabilize the market and boost overall spending within the economy. They implemented large-scale asset purchases, including acquiring over 400 billion Canadian dollars worth of government bonds and other financial assets by essentially printing money. These purchases effectively restored activity in the financial markets, as individuals preferred to sell their assets to have more cash on hand during the pandemic, particularly in a near-zero interest rate environment. The purchase of Canadian bonds, commonly known as quantitative easing, was intended to stimulate the economy by injecting households and businesses with more cash and offering cheaper loans to encourage spending on goods, services, and housing. However, this influx of money into the economy has led to concerns of overheating.
When people have money, they tend to spend it. The more money they have, the more they tend to spend. In late 2020 and early 2021, Canadian households began to tap into their pent-up pandemic savings and excess cash, even as production struggled to fully recover due to labor shortages, supply chain disruptions, and rising energy prices. In accordance with the basic demand-supply economic model, it’s evident that when there’s too much money chasing too few goods, prices rise. In other words, as the Central Bank printed money and injected it into the economy and consumers’ pockets while the supply side experienced shutdowns and production constraints, inflation naturally occurred.
Understanding the link between money supply, or the monetary aggregate, and inflation is crucial. As discussed in a previous blog post, concerns had arisen about the possibility of Canada entering a recession. However, by comprehending one of the root causes of high inflation, we can confidently predict that price levels will eventually return to normal once the money supply stabilizes. According to the latest data, we can observe that both the monetary aggregates M1+ and M2 are contracting, and inflation is gradually receding. For instance, as mortgage renewals are initiated with higher interest rates, money will flow back into the banking system. While we may not anticipate immediate results from monetary policies such as increasing policy rates, we do recognize that reducing the money supply will exert downward pressure on inflation and eventually yield positive outcomes.
Photo by Josh Appel from Unsplash
