When supply shocks make inflation harder to control

Supply disruptions were a key driver of inflation during the pandemic. If such disruptions occur more often in the future, they could lead to more frequent and persistent periods of high inflation. Central banks could then find it harder to bring inflation back to target while supporting economic activity.

Inflation can rise for different reasons. Strong demand may push spending beyond an economy's capacity to produce. A disruption or shock to supply—like an unexpected global shortage of semiconductors—may raise costs for businesses or make products hard to find for consumers.

These supply- and demand-related forces also affect economic activity, but in different ways.

A sudden increase in demand tends to push up both economic activity and inflation. But a sudden decrease in supply can make inflation and economic activity move in opposite directions: activity declines while inflation rises.

This difference can create a dilemma for central banks. When inflation is driven by supply disruptions, raising interest rates can help bring inflation back toward target but may also weaken economic activity. Holding rates steady may support activity but may allow inflation to be elevated for longer. Understanding what is driving inflation is therefore critical when assessing different monetary policy responses.

The dilemma could become more challenging if supply shocks become larger and more frequent than in the past. Our analysis shows that larger supply shocks increase both how often core inflation rises above 3% and the risk of a recession.

Both demand and supply forces affect inflation—and identifying them is key

The first step in our analysis is to identify whether changes in Canadian inflation in the past have been driven by demand or supply factors.

To do so, we use detailed spending data from Statistics Canada on prices and quantities for 96 categories of goods and services. We classify a price change as demand-driven when the price and quantity in a category move in the same direction and as supply-driven when they move in opposite directions. Then we combine the categories using their shares of household spending to break down the contributions of demand and supply factors to total inflation.

This approach produces intuitive results. Demand-driven inflation generally falls during recessions—when spending weakens—while supply-driven inflation varies more over time, reflecting changes in production capacity, energy prices and other costs (Chart 1).

However, this method has limits. Supply and demand shocks can occur at the same time, so the classification system captures only the main source of movements within a category.

Supply forces drove much of the surge in inflation in recent years

Focusing on recent years, we see that demand-driven inflation initially turned negative at the start of the pandemic (Chart 2). Public health restrictions forced stores to close and consumers to stay home, leading to a drop in spending. Inflation then rose sharply as the economy reopened and consumers rapidly increased their spending, drawing on savings they had accumulated during the pandemic.

Although demand forces contributed to this rise, supply-side factors drove the largest share of the increase. For example, the surge in inflation of goods prices largely reflected shipping bottlenecks, shortages of key inputs and higher energy prices. And for services, it partly reflected labour shortages and capacity constraints that added supply pressures.

Supply-side challenges later eased, helping bring inflation back toward the midpoint of the Bank of Canada’s 1%–3% control range.

Over the coming years, supply shocks could continue to be more frequent and larger than before the pandemic because of climate-related disruptions, geopolitical tensions and the reshaping of global trade networks. These forces could put renewed pressure on energy costs and supply chains, making supply-side factors a more frequent source of inflationary pressures.

Large supply shocks increase the likelihood of high inflation and a recession

To better understand how more frequent and larger supply shocks could affect the economy, we turn to the Bank’s Terms-of-Trade Economic Model.

Starting with a stable economy in the model, we generate thousands of possible economic paths by repeatedly exposing the model to supply and demand shocks consistent with historical patterns. The model then traces how inflation, output and interest rates evolve over time.

We run three sets of simulations, each representing a different supply-shock environment. The supply shocks differ only in size and frequency—the persistence is held constant. Each simulation is calibrated using supply shocks estimated from different periods of Canadian economic history:

• the normal case uses supply shocks from 1995 to 2019
• the moderate case uses supply shocks from 2022 to mid-2025
• the large case uses supply shocks from 2020 to mid-2025, which include the exceptional disruptions during the pandemic

The results show that moderate supply shocks make episodes of high inflation more frequent than in the normal case, but they do not significantly lengthen those episodes or greatly increase the risk of a recession (Table 1).

The picture changes when supply shocks are large. High inflation sticks around for about two quarters longer than it does in the normal case. The risk of a recession also rises, but the length of a recession changes little because our simulations increase the size of a shock and not its persistence.

Note: Core inflation is the average of CPI-median and CPI-trim. The calibration periods indicate the sample period of historical data used to calculate the volatility of supply shocks; for the moderate and large supply-shock environments, the periods end in the second quarter of 2025.
Source: Bank of Canada calculations

Supply shocks complicate decisions for policy-makers

But what does a world with more frequent and larger supply shocks mean for setting monetary policy?

Our analysis suggests that central banks may face a difficult balancing act more often. When supply disruptions push inflation higher, raising interest rates can help bring inflation back toward target but may also further weaken economic activity. With more frequent supply disruptions, the trade-off between restoring price stability and supporting economic activity is present more often.

In such an environment, analytical tools like those presented here become increasingly important. Though they cannot eliminate difficult policy choices, they can help policy-makers better understand the forces driving inflation and assess the trade-offs involved in responding to them.

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