Canadian Inflation Turns the Corner…But Not on Two Wheels

Canada's inflation trends are looking a lot like the trends in the United States. The headline inflation rate has rolled off relatively sharply. The year-over-year pace is 5.3%; that falls to 3.3% expressed at an annual rate over six months. The annualized pace logs a 1.6% gain over three months. Magically inflation goes from extremely strong to under the pace prescribed by its target. Canada’s CPIx, which excludes the most volatile components of inflation, shows a 4.9% increase over 12 months, a 3.7% annual rate increase over six months and a slightly slower 3.4% annual rate increase over three months. Those metrics track closely the U.S. CPI path. Meanwhile, Canada's core CPI rate (excluding food and energy) shows a 6% gain over 12 months, a 4.3% annual rate increase over six months and a 4.1% annual rate increase over three months that echoes the pattern of the U.S. core. Although Canada has a lower inflation rate on each of its shorter horizons compared with the U.S. core with the three-month inflation rate pace that's a percentage point below the 3-month pace in the U.S., Canada's year-over-year pace for the core is 1/2 of one percentage point higher than in the U.S. It's too soon to say exactly what this means in terms of policymaking and whether we should be paying more attention to the year-over-year pace or to the 3-month pace. But the differences here are not huge.

When the 3-month inflation rate drops sharply, it's an encouraging sign about where inflation is headed next. However, it is not a guarantee. The ‘problem’ with annualized 3-months inflation is that the series is volatile. A drop in inflation over 3 months is a welcome signal, but it is not one that can be relied on up. That is the policy dilemma.

Canada’s year-over-year inflation rate on the CPI peaked at 8.1% in June and has declined to a pace of 5.3% in February. The CPIx pace that excludes the six most volatile items peaked at 6.2% in June and is down to a pace of 4.7% in February. Canada’s core CPI peaked at 5.5% in July and is down to a 4.9% pace in February, the same as its year-on-year pace in January.

Inflation volatility Each of these three measures peaked within one month of the others. The current year-on-year inflation pace for each index is different but not by much 5.3% vs. 4.7% vs. 4.9%. There is much more difference among the less reliable 3-month gains 1.6% vs. 3.4% vs. 4.1%. Headline inflation shows the smallest gain on weak energy prices. The core has the strongest 3-month gain.

In all cases, 3-month (annualized) inflation is more volatile than its 12-month percentage change. EMU HICP inflation has the highest 12-month variability characteristics and one of the smallest step ups in comparison with its 3-month pace (still the most volatile among the 3-month paces). The Canadian core has smallest variability in 12-month inflation and the smallest step up from that to 3-month inflation. Headline inflation in the Canada and the CPIx have step ups from the 12-month variability to the 3-month variability from 39% to 47%. U.S. headline inflation volatility steps up by 28%. U.S. core inflation has a step up of 35.8%, a higher step up than for U.S. headline inflation and double the step up for Canadian core inflation but still the second lowest variability for 3-month inflation in the table. This table suggests Canadian core and U.S. core inflation are the 12-month and 3-month inflation rates to watch. It’s interesting that the de-volatized Canadian CPIx does not perform better in absolute or relative terms.

The monthly Canadian data show results for the headline and core monthly percentage changes. For a 2% inflation rate to endure, every three-month span must show gains of 0.2%, 0.2% and 0.1% - or their equivalent. The Canadian core shows no sign of any patten like that. Canada’s headline doesn’t either, but it produces a lower result (for 3-month inflation) on a zero gain, a 0.3% gain and a 0.1% gain as commodity process have fallen and been somewhat volatile. The headline’s recent history has not ‘settled down’ and does not look either reliable or tranquil. Thus, the favorable 3-month reading on headline inflation does not look dependable, despite its result being desirable. With China heating up, energy prices would seem to be in for more pressure. But if global recession is coming, there should be less pressure. If the now global-looking banking crisis continues to spread inflation and growth should be reduced. But those are a lot of ‘ifs.’ Monetary policy should not be iffy.

The table memorializes inflation trends in Canada, the U.S., and the EMU. In all these locales, inflation is clearly excessive.

On balance, these data point to inflation as an enduring problem. It is eroding, and progress is being made. But the pace of erosion on our most trusted measures is slow. The outlook for inflation is still ‘iffy’ depending as it does on some unknowable outcomes. But ‘the press’ is creating hoopla over the possibility that central banks have the option to pursue ‘stability policy’ and hold off on rate-hiking ‘for a while.’ The claim is that such a choice could jeopardize inflation fighting. On closer inspection, this does not seem to be much of a risk. Financial insecurity generally undercuts confidence and growth so central bank prevarication in the face of such a crisis is hardly opening the door to more inflation. Moreover, by passing an opportunity to head off a banking/financial crisis is not a good idea-ever. As the table shows, in none of these three regions is inflation accelerating nor does it require especially aggressive action (EMU is the farthest behind in its inflation fighting, and it did not slow down at its last meeting).

Do not worry about the false policy dilemma posed by the press. It really does not exist. Central bankers instead need to look at their circumstances and decide if their financial risks are significant and might be worsened by policy rate hikes then make their decisions. Canadian banks have lost a significant amount of bank capitalization, but Canadian banks do not seem to face any particular threat. However, Canada’s bank regulators will have more detailed and timely information on this. Canada’s ‘Big Six’ banks are stable. And smaller banks are, well, much smaller. Canadian authorities seem to have little fear of small bank contagion that could have any systemic consequences.