Bank of Canada staff paper finds supply shocks drove majority of Canada's post‑pandemic inflation

New Bank of Canada staff research says supply-side pressures were the bigger driver of Canada’s post-pandemic inflation surge, while interest rates mainly work on the demand side of the economy.

That matters because it helps explain both the power and the limits of monetary policy. Central banks can cool spending and borrowing by raising rates, but they cannot directly fix supply disruptions such as energy shocks, imported input shortages or other bottlenecks. The new paper offers fresh Canada-specific evidence on that divide.

In the July 2 staff paper, “Supply and Demand-Driven inflation: Decomposition and policy implications,” Bank of Canada researchers Kira Kang, Temel Taskin, Rodrigo Sekkel and Jing Yang wrote: “We find that both supply and demand forces contributed to the post-pandemic rise in inflation, with supply-side pressures accounting for the larger share.”

The paper’s second headline finding goes to the heart of rate-setting: “Contractionary monetary policy shocks lower demand-driven inflation but have little effect on supply-driven inflation.” The authors also said estimates based on a targeted Taylor rule — a standard framework for describing how central banks respond to inflation and economic activity — suggest the Bank of Canada responds more strongly to demand-driven inflation than to supply-driven inflation.

The analysis is based on detailed household spending data from Statistics Canada covering 96 goods and services categories, from 1990’s fourth quarter through 2025’s second quarter, with results in the paper running through 2025’s third quarter. Using quarterly household final consumption expenditure data, the researchers sorted inflation by looking at how prices and quantities moved within each category.

In plain terms, when prices and quantities in a category moved in the same direction, the inflation in that category was treated as more consistent with stronger demand. When prices and quantities moved in opposite directions, it was treated as more consistent with supply problems. The paper says the approach follows a decomposition method associated with Adam Shapiro of the Federal Reserve Bank of San Francisco, adapted here for Canadian data.

The paper uses the Bank of Canada’s trimmed-mean core inflation measure, which removes 40% of the consumer price index basket by trimming 20% at each tail. That is one of the Bank’s preferred ways to filter out unusually large price swings and gauge underlying inflation pressures.

The findings add to earlier evidence that Canada’s inflation burst was not mainly a simple story of overheated demand. A May 2024 Statistics Canada analytical note found that during 2021 and 2022, quarterly household final consumption inflation averaged 5.99%, with about 54.0% attributed to product-specific supply shocks, 23.7% to product-specific demand shocks and 22.3% to aggregate demand shocks.

The policy backdrop is that the Bank of Canada on April 29 held its benchmark interest rate at 2.25%, saying headline inflation had risen in March partly because of sharply higher gasoline prices and projecting inflation would ease toward about 2% by 2027. But the new paper is not a policy decision or a signal of a formal policy shift. As the paper states, “Bank of Canada staff research is produced independently from the Bank’s Governing Council and may support or challenge prevailing views. The views expressed in this paper are solely those of the authors and may differ from official Bank of Canada positions.”

The authors also caution against reading the exercise as a perfect separation of inflation into two neat buckets. Their method, the paper says, “identifies whether a category’s price–quantity comovement is more consistent with a supply or a demand shock, but it cannot rule out the possibility that both shocks occur simultaneously. ... the method does not recover the magnitude of the shocks, only their inferred direction.”