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Economy in Brief

Canada and G7 Inflation Pressures
by Robert Brusca  May 15, 2019

Canadian headline and core inflation both end April either at the 2% mark or above the 2% mark. The CPI-X lags with a 1.5% pace year-over-year. So has the bank of Canada hit its target or not? For Canada, that is more a matter of judgement than it is most places.

Canada has a different approach to inflation targeting than other central banks as it has a 1% to 3% target for the headline and aims to keep the rate at the midpoint of 2% 'in the medium term.' The 'medium' term is that special fairly land in which central banks make policy and that we are never able to directly observe. It is more secretive than Burger King's special sauce or the formula for Coca Cola or Tim Hortons business strategy. The Bank of Canada has a policy of 'typically being effective' in a period six to eight quarters, or so it says. But that is not a promise or a firm timeline. Unlike other central banks, the Bank of Canada renews its target periodically. It has reaffirmed its 1-3% range with the objective being at its midpoint of 2% for the next five years. The new regime was reset back to in 2016. Also the Bank of Canada looks at several inflation measures to gauge the inflation rate; they are the CPI-common, the CPI-trim and the CPI median.

Canada's inflation trends are very similar to the trends we see globally. Among the G7 countries, Japan has tended to have the most persistently weak inflation owing to its ongoing demographic shrinkage and also because of a series of shocks it has been subjected to along with the discipline it has had forced upon it by having China as its most important trading partner.

Canadian core prices are running at a pace around 2% along with the Canadian headline. But the Canadian CPI-X is weaker and more in line with the sorts of increases that we are seeing in U.S. Core CPI prices and from the EMU. Canada's CPI-X is a more ambitious version of the CPI-core. The core removes food and energy to rid the measure of components that tend to be volatile. The CPI-X rids the CPI of eight components chosen for removal precisely because of their intrinsic volatility. However, inflation is a fickle thing even if we look at similar core measures for the U.S., Canada, EMU and Japan. Even there we find a lot of variation despite low inflation everywhere and more or less the same target.

In the Japan core index (red line), you see the clear impact of the rise in its VAT tax in 2014. Since the chart plots year-on-year percentages and since Japan's underlying inflation rate was low and stable, the VAT gain dominates the CPI core for one year making it graphically look like a mesa. When the VAT kicks in, the inflation rate shoots up stays higher then drops back after one year. The U.S. and Canada have rates that are close together; that does a good deal of mutual tracking over time. The EMU core rate is considerably different. And even with the VAT out of the Japanese data, Japan's inflation is simply different, lower.

Despite these differences exchange rate changes have been relatively tranquil over the past seven years. But over time persistent differences in inflation will create differences in competitiveness. These differences could require exchange rate realignment.

Prices in the U.S. and in Canada on comparable measure (core) are closest to their target. Of course, one important caveat is that I have used CPIs here and in the U.S. the Fed targets the PCE. The PCE is weaker than the CPI with the PCE core up at just a 1.3% pace over 12 months and the headline is up at a 1.6% rate. The U.S. PCE is running cold.

How far apart these measures are from their 'goal' is less a numerical question and depends in part on central banks and on how sharply they want their objectives defined. Canada shoots at the mid-point of a two percentage point range. That is very hittable. The ECB gave itself plenty of space looking for inflation of a less than 2% but seemingly is less concerned if inflation is lower depending on the economic growth situation and EMU political pressures. In Japan, there is a 2% target that has not been hit except for the VAT introduction which doesn't count. In the U.S., there is a 'point' target and the Fed has been below much more often than above it.

In the U.S., some want to take the target somewhat literally as narrow as it is and seek a symmetric approach so that policy misses on the upside as much as it does on the downside. That has yet to happen. Canada with a range target has flexibility to call slight undershoots of 2% acceptable or not. The ECB has chosen to draw its hard line on the top and because of that it is winding up with policy discord when inflation undershoots substantially. In the ECB, everyone seems to agree than inflation of more than 2% is 'bad.'

Central banks have found many different ways to manage inflation even when they may seem to be doing the same thing. Beyond that, there is the question of why 2%? It's a question no one really answers. And should inflation rates internationally converge? It seems that they should, but the EMU inflation measure does not have housing costs in it while housing costs are one of the largest items in the U.S. inflation index. I still tend to think in terms of getting inflation rates harmonized internationally since once inflation is harmonized and managed at a 2% pace most any reasonable price index will be moving at a 2% pace. It is only when there are disruptions and when relative price are being reset that the choice of an inflation measure really matters. And that is true whether the cause is inflation getting out of control or just a sector price shock. Unfortunately, the reality on this score is that there are a lot of shocks and they seem to hit countries differently or at different times and that makes the choice of price index more important. Giving the price indexes the same name does not help to solve the problem.

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