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Why Canada's inflation rate disappointed some analysts and the full circle argument

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Alex Carrick

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Alex Carrick is Chief Economist for Reed Construction Data. He specializes in economic forecasting and statistical services.

Economists

Apparently, many analysts were disappointed that Canada’s inflation rate wasn’t high enough in December 2009. The all-items Consumer Price Index (CPI) was +1.3% year over year. The Bank of Canada’s target is +2.0%. The shortfall took some of the luster off the loonie and stock prices. But let’s not be in too big a hurry to see inflation climb in Canada. On balance, the BOC should not be afraid to raise interest rates before the Fed.

Apparently, many analysts were disappointed that Canada’s inflation rate wasn’t high enough in December 2009. The all-items Consumer Price Index (CPI) was +1.3% year over year. The Bank of Canada’s target is +2.0%. The shortfall took some of the luster off the loonie and stock prices. Actually with respect to the latter, the cause was more to do with China’s steps to slow down too-rapid growth. Worries about overheating in China are being met with monetary restraint.

A misreading of the situation

Getting back to Canada, however, the disappointment over the inflation rate involves some misreading of the situation. The BOC’s +2.0% target is for when the economy is behaving more normally. What should be looked for is a progression towards that level as the recovery takes firmer hold. Otherwise, there is the risk of overshooting the mark too early in the next up-cycle. That will then have serious implications in terms of a need for too-restrictive interest rates.

The neutral central bank rate – which neither offers too much stimulus nor takes too big a bite out of growth – is traditionally somewhere around 2.5% to 3.5%. Rates are being kept so low right now because there is concern that the recovery is fragile. Forecasters have a funny job. A part of their role is to speculate on what they will see in their rearview mirrors. For example, in six months’ time, it will probably be judged that rates have been kept too low for too long.

Worries about the value of the loonie

The Bank of Canada is afraid to raise rates due to the effect on the value of the loonie. There has already been considerable updraft under the loonie due to rising world commodity prices. The effect has been magnified by a U.S. dollar that has come under selling pressure in world currency markets. With respect to Canada’s overall economy, a high-valued loonie hurts export sales.

The greenback has been in trouble due to weak U.S. economic growth, fiscal excess in Washington (whether justified or not) and a nearly 0% federal funds rate. As U.S. recovery proceeds, the greenback will rebound somewhat, especially if there is a backdrop of slower growth in China and moves taken by the Japanese government to lower the value of the yen.

The Japanese need both a boost to their export sales and a jolt to their domestic prices that would come from a weaker yen. That nation has been habitually fighting deflation. Like China, it has considerable control over the value of its currency through massive foreign exchange holdings.

For Canada, there is an anomaly in its currency/inflation configuration – the higher the value of the loonie, the lower the price of imports. This helps to restrain inflation, not just through lowering the cost of imports but by forcing domestic producers to keep their prices down on competing products. Current logic seems to suggest the following ideal timing scenario for the Bank of Canada. Such a progression would see the U.S. Fed raise interest rates ahead of the overnight rate in this country. That would take pressure off the loonie and cause inflation to climb. For older economists, those final four words – “cause inflation to climb” – are jarring.

But old-time economists take a different view

Old-time economists, at least those who had careers in the early 1980s, are always on the lookout for too rapid inflation. They know that the perils of hopped-up prices are many and that they can make life miserable. If earnings don’t keep up, which they usually don’t – especially for seniors and others on fixed incomes – living standards plummet. The only cure is high interest rates.

While it may seem that this is just a theoretical discussion at this time, consider again. Has this article not just come full circle in its portrayal of one set of current circumstances? The problem of asset price bubbles and potentially runaway inflation is exactly what China is encountering. Beijing’s response has been monetary tightening. Let’s not be in too big a hurry to see inflation climb in Canada. On balance, the BOC should not be afraid to raise interest rates before the Fed.

Alex Carrick

Find Canadian construction-related economic articles in Canadian Construction Market News and in the Economic Outlook section of Daily Commercial News. Mr. Carrick also has a lifestyle blog that can be reached by clicking here.

by Alex Carrick

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