Is the Bank of Canada less concerned about inflation picking up?
On Oct. 23, the Bank of Canada did the expected and maintained its target for the overnight rate at 1 per cent. The decision in itself caused no surprise whatsoever. However, the wording of the decision was sufficient to cause the Canadian dollar to fall half a cent against its U.S. counterpart following the announcement – and it continued to fall another 1.5 cents in the week since.
What surprised the markets was the fact that the Bank of Canada removed all trace of its usual tightening bias, meaning that it is no longer repeating the following sentence in its policy statement: "Over time, as the normalization of these conditions unfolds, a gradual normalization of policy interest rates can also be expected, consistent with achieving the 2 per cent inflation target." The central bank also lowered it growth targets for the years 2013 to 2015, showing the markets that some of its optimism has faded. The markets did expect the bank to lower its forecasts, but the removal of the tightening bias did catch markets largely off guard.
But should we really be surprised that the bank stopped warning that inflation should pick up any time now? No.
Inflationary pressures? Where?
It's no secret that inflation is nowhere to be seen in the world's advanced economies, even though many had feared that the accumulation of ultra-expansionary monetary policies would cause world prices to spiral out of control. After all, are we not taught that printing money leads to a rise in prices? Well, actually, that depends. So far, it seems that the added liquidity inflated asset prices instead of consumer prices.
Central banks around the world have done two things in the past few years: They have kept interest rates at record lows and used unconventional tools such as quantitative easing, which consists of printing money to buy (mostly) government debt. In doing so, they succeeded in keeping long-term interest rates (which they do not directly control through their monetary policies) low, and allowed the world's governments to borrow at the precise moment when the economy needed someone to step in and avoid a depression like the one in the 1930s.
The storm has mostly passed, and many are now nervous that the solution to the depression problem will lead to inflation that could be very difficult to contain. But instead, what we are actually seeing in many industrialized countries is disinflation – inflation rates are going down, not up.
In Canada, the central bank's headline inflation rate sits at 1.1 per cent, after spending part of the last year below the target range of 1 to 3 per cent that the bank uses to guide its rate policy. The bank's all-important core measure, which excludes the most volatile components of consumer prices, is also bouncing against the lower end of the bank's inflation target range, at 1.3 per cent. In fact, the core inflation rate has remained around the lower end of the bank's target band over the past four quarters, the longest stretch, outside of the 2008-09 financial crisis, since the Asian crisis 15 years ago.
In the United States, the favoured inflation index used by the Federal Reserve is the personal consumption expenditure (PCE) inflation index, which focuses on household consumption. It more efficiently tracks the effective inflation rate, because it allows the weights of each component to move with trends in consumption. This index has been on a steady decline since early 2012, and now shows an inflation rate barely above 1.2 per cent. The Canadian equivalent of this measure is the deflator of the household final consumption expenditure component of gross domestic product (GDP), which suggests that Canadian inflation is even weaker, at 0.8 per cent. (see Chart 1)
We can also anticipate future inflation by looking at the evolution of producer price indexes, which measure the change in costs charged to producers that will be passed on to consumers within a year. There too, levels are depressed (see Chart 2) – indicating that there is no inflationary pressure in the pipeline. Commodities prices are deflating and global demand remains weak over all, making it hard to predict an upturn in basic materials prices in the foreseeable future. With China and most emerging markets looking at slower growth than 10 years ago, commodity prices are not likely to push production costs up like they previously did.
Uncertainty in measures of current and future output gap.
Considering that the Canadian economy is facing potential headwinds at home with a deleveraging consumer and lower commodities prices, it is hard to fathom inflationary pressures forming domestically.
Before producers start raising their prices, the slack in the economy must be reduced significantly; instead, the Bank of Canada's latest Monetary Policy Report shows that Canada's excess capacity is still increasing. And estimating the level of potential GDP (and, at the same time, the output gap) is not an exact science; there could be more slack in the Canadian economy than the central bank assumes. Readers should take a look at the latest speech from Bank of Canada deputy governor Agathe Côté for a better understanding.
The data have shown that the real dangers facing Canada are, first, weakening commodities prices stemming from technological innovation, and, second, a possible bumpy landing in real estate. Don't be surprised if down the road the Bank of Canada revises again its estimate of the level of slack in the economy, and becomes more worried about disinflation than inflation.
Unlike a year ago, given the probable underperformance of the Canadian economy, we now expect the Bank of Canada to start raising rates later than the Fed. And that's a recipe for a further decline in the Canadian dollar.
Clément Gignac is senior vice-president and chief economist at Industrial Alliance Insurance and Financial Services Inc., vice-chairman of the World Economic Forum Council on Competitiveness and a former cabinet minister in the Quebec government.