- Inflation landed on the screws in September
- Core inflation has remained resilient through the pandemic…
- ...after subsiding largely just before it struck
- There is no evidence of broad deflation risk...
- ...but years of undershooting 2%...
- ...have dislodged expectations…
- ...which jeopardizes the ability to sustainably hit the target...
- ...requiring further efforts by the BoC
Canadian CPI, y/y % / m/m % NSA, September:
Actual: 0.5 / -0.1
Scotia: 0.5 / -0.1
Consensus: 0.5 / -0.1
Prior: 0.1 / -0.1
Canadian core CPI, y/y % change, September:
Average: 1.7 (prior 1.7%)
Weighted median: 1.9 (prior (1.9%)
Common component: 1.5 (prior 1.5%)
Trimmed mean: 1.8 (prior 1.7%)
Core inflation remains resilient at 1.7% y/y and hence still within a tight 1.6–1.7% band that has operated since April. (chart 1) How will the Bank of Canada treat this in next week’s communications and beyond? Assuming that an election call doesn’t shift the BoC to the sidelines pending today’s confidence vote, I think they’ll continue to emphasize that more needs to be done.
First, some background on how we got here. Downward pressure was in place before the pandemic struck when core inflation peaked at 2.1% y/y in November of last year and slipped to 1.9% and hence below target by February and then 1.8% the following month as the shutdowns occurred over the second half of March. Transitory factors that boosted core inflation toward 2% last year were ebbing even before the pandemic. This was the driver I was emphasizing a year ago into early this year as behind the forecast that even before the pandemic struck, the BoC was likely on a modestly easing path that obviously then became massive easing during the pandemic itself.
But how might the BoC react to resilient core inflation now? We may hear directly from them next week. In my view and at a minimum, they are likely to continue to downplay deflation risk thanks in part to global and domestic stimulus efforts, while nevertheless emphasizing that underlying inflation drivers remain below target and in need of proving that the target is indeed a symmetrical one. That probably puts them in the middle ground between being encouraged by fairly resilient core inflation, while nevertheless cognizant toward years of undershooting that has presented the risk of permanently unmooring inflation expectations. That, in turn, makes it more difficult to sustainably achieve the symmetrical 2% inflation target over time.
The broad evidence is compelling. The BoC formally targets headline inflation to be “the 2 per cent midpoint of an inflation-control target range of 1 to 3 per cent...expressed as the year-over-year increase in the total consumer price index (CPI)”. Operationally, it focuses upon core which weeds out factors that are too volatile or beyond the influence of domestic monetary policy.
Over the past decade, the BoC has largely fallen short of its operational target as seen in chart 1 and never succeeded in proving it to be a symmetrical target with sustained periods of overshooting to average out at around 2% over time as mandated. In fact, out of 129 monthly observations since 2010, average core inflation has been sub-2% 120 times, or 93% of the time. A symmetrical target in theory has been treated as an asymmetrical target with policy swings guided toward achieving inflation in a sub-2% way over the cycle and treating 2% as a ceiling. They are not alone in this regard by any means as undershooting inflation targets has tended to be the norm across major global central banks against secular forces guiding inflation lower.
As a result, market-based measures of longer-term inflation expectations have done likewise and persistently cruised beneath 2% including right up to today (chart 2). These are imperfect guides derived from where nominal Government of Canada and real return (RRB) bonds are trading and can be influenced by liquidity, efforts to depress term premia through global and domestic policy forces etc.
It’s therefore useful to cross check market measures against other measures of inflation expectations. Business expectations for inflation have tended to be moored in the 1–2% range over the past decade. The BoC’s Business Outlook Survey (here) depicts this by showing the combination of businesses expecting inflation to be in the sub-1% and 1–2% bands summing to over 50% more often than not (chart 3). In fact, since 2010, businesses have said that inflation will ride in the sub-2% range 74% of the time across the quarterly surveys.
Consumer-based expectations are persistently too high and probably the least relevant gauge (chart 4). The BoC’s Survey of Consumer Expectations (here) shows that throughout the undershooting period, consumers have believed inflation to be running well over 2% on average across 1, 2 and 5 year timeframes. They tend to view inflation as reflecting their own individual baskets of frequently purchased items which results in a distorted impression than a constant weight basket of frequently and infrequently made purchases with quality adjustments over time. Personally, I pay almost zero attention to this metric.
The way to reconcile this from the standpoint of the market’s understanding is, in my view, to emphasize expectations for ongoing and further stimulus rather than prematurely declaring victory. This issue is at the center of the BoC’s strategic review that is underway. It’s unclear markets can afford to wait until the likely communication of the decided framework sometime in 2021H2 that includes consideration of an average inflation targeting framework such that developments may overtake the review as was the case with the Federal Reserve. In the case of the BoC, however, the existing 2% +/- 1% symmetrical targeting framework may offer adequate flexibility as long as there is increased emphasis upon the symmetry part. Whether they’ll succeed over time or not depends on many factors such as the ability to engineer faster inflation and whether the bond market will stand idly by as inflation is allowed to drift north of 2%.
Charts 5–8 provide the usual drivers of the year-over-year and month-ago inflation measures in weighted and unweighted types. The top drivers of the year-over-year rate are vehicle prices, restaurant prices (huh?!), auto insurance partly keyed off vehicle prices, and housing related categories.
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