With July inflation ramping up again on Tuesday, it’s obvious the battle ain’t over yet. The headline inflation rate jumped to 3.3 per cent from last month’s 2.8 per cent. While mortgage costs and food are major contributors to our stubborn inflation, energy prices have risen 5.8 per cent in the past four months, thanks in part to the carbon tax hike last April 1.

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Jack Mintz: Carbon taxes make the Bank of Canada’s job harder Back to video

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As the world continues its march to net-zero emissions by 2050, an interesting debate is rearing its head as to whether the energy price inflation will affect monetary policy. That point was made last year by Isabel Schnabel, a member of the European Central Bank’s Executive Board: “As we build a more sustainable economy, we face a new age of energy inflation … that can be expected to lead to a prolonged period of upside pressure on inflation,” she warned.

Putting it in simple terms, carbon policies not only lead to more inflation but could contribute to higher interest rates when central banks fight inflation. So, if Canadians are already suffering from energy costs that filter through the whole economy, they will also face higher interest rates as well. Good for savers but bad for borrowers.

That conclusion is not without controversy. Monetary policy is focused on inflationary expectations. Expectations are important because firms will raise prices and workers will bargain for higher wages if they believe prices will continue to rise. If inflation is above the target rate — two per cent — inflationary expectations that are currently well above the target rate push central banks to raise interest rates.

The argument that energy prices influence inflationary expectations runs as follows. The energy price is obviously an important part of transportation costs (gasoline, aviation and diesel fuel), heating costs (natural gas) and electricity utility bills. However, energy is a critical input for every industry so higher energy prices will cause firms to raise prices to maintain profit margins and workers to bargain for higher wages as we have seen lately with the Metro supermarket and Vancouver port strikes. The key issue is whether energy prices that are highly volatile become imbedded in inflationary expectations or not.

The volatility in energy prices is illustrated by the accompanying graph for unleaded gasoline prices in Canada. Gas prices have risen from $1.12 per litre as of January 2017 to $1.60 as of April 2023. However, they peaked at $2.07 in June 2022 and were as low as 78 cents a litre in April 2020 during pandemic lockdowns. No doubt the trend is of rising gasoline prices since 2018, reflecting both carbon taxation (now 14 cents a litre) and rising global oil prices due to supply not keeping up with demand.

The question as to whether carbon pricing contributes to higher price expectations is taken up in a new CESifo paper written by Jannik Hensel, Giacomo Mangiante and Luca Moretti. Using firm-level data on realized and expected prices of French companies during the years 1999 to 2019, the authors found that carbon price shocks under the EU Emissions Trading System that started in 2005 have become embedded in inflationary expectations. They found that a rise in energy prices of one per cent resulted in expected consumer prices to cumulatively rise by 0.2 percentage points in the first two and half years and then decrease thereafter.

This is a pretty significant conclusion, consistent with the Canadian experience. Bank of Canada Governor Tiff Macklem made it clear in May 2022 in a reply to the House of Commons finance committee, that federal carbon taxes that were $50 per tonne added 0.4 percentage points to Canada’s realized inflation rate.

Monetary impacts are new fodder for federal Conservative Leader Pierre Poilievre, who has been quite strident in his attacks on federal carbon policies as an inflationary source. Carbon taxes are to be hiked from $65 per tonne (as of April 1, 2023) to $170 per tonne by 2030. “Carbon tax 2.0” (the federal clean fuel regulations) will further raise gasoline and diesel prices by 17 cents. Combined, carbon taxes and the CFR by 2030 will cost consumers 54 cents a litre for gasoline, almost four times higher than today’s 14 cents per litre. If these energy price hikes become imbedded in inflationary expectations, they will keep interest rates higher, too.

Carbon pricing is beginning to lose its lustre. As a recent Nanos poll reported, almost two-thirds of Canadians believe the recent hike to carbon taxation was poorly timed. A majority believe that carbon taxation is ineffective. Carbon policies become ineffective in curbing emissions when consumers have few choices to curb consumption. When it is cold, heat must be turned on, and when it is hot, air conditioning is a must. Public transport and EVs are not options for many Canadians, especially in smaller cities and rural Canada.

And if a connection is made between rising energy prices and interest rates, Canadians will have another reason to dislike inflationary carbon policies. Canadians already feel under siege with rising costs for transportation, housing and food. Add on mortgage costs, and politicians will face a tsunami of angry voters looking for new answers from all political parties next election.

Financial Post