Canada's inflation heated up a bit in June. And frankly, the Bank of Canada doesn't care.
That might sound odd for anyone who has followed Canadian monetary policy for the past quarter-century. It was in 1991 that the central bank adopted an explicit inflation target as its guide for setting interest rate policy. The bank's expressed sole aim with its policy is to achieve stable inflation around its 2 per cent target.
To filter out all the noise around short-term gyrations in consumer prices, the central bank focuses its attention on the core inflation rate, which excludes the eight most volatile components of the Consumer Price Index. In theory, and often, in the past, in practice, nothing else should matter to the central bank in determining what to do with interest rates.
But just days after the Bank of Canada sprung another interest-rate cut on Canadians, the second this year, Statistics Canada reported Friday that Canada's CPI inflation rate posted its third straight increase in June.
Granted, that only puts it at 1.0 per cent – the bottom of the central bank's 1-to-3-per-cent range around its target. But the core rate, the one the bank is supposed to be focused on, rose to 2.3 per cent – its 11th straight month above the 2-per-cent target.
That looks like more than enough of a trend in the core rate to conclude that at its heart, the country's inflation is on the hot side of the central bank's goal, if only modestly so. If the core is running above target, it wouldn't normally signal that the Bank of Canada has a need to cut interest rates. Yet it has. Twice.
So why is our central bank ignoring its own policy guide?
Well, the simple answer is, it's not. Not really, anyway. It just doesn't believe the core inflation rate is really saying what it appears to be saying.
In its closely watched quarterly Monetary Policy Report this week, the bank reiterated something it has been saying for a while now: That the core rate is overstating the true underlying inflation in the Canadian economy. It is being juiced by some temporary rises in a few isolated components of CPI, and, more importantly, by what it calls the "pass-through effects" of the Canadian dollar's depreciation over the past year or so.
Those currency effects don't reflect actual inflation pressure caused by an accelerating Canadian economy and growing pressures on the country's production capacity; indeed, the Bank of Canada believes that due to the economic sluggishness of the first half of the year, spare capacity in the economy has probably increased. So it's trying to look through the currency effects and gauge more meaningful underlying pressures on prices.
Assessing a variety of alternative inflation measures, the bank believes that true underlying inflation is more like 1.5 to 1.7 per cent – a tick down from its previous quarterly estimate in April, and thus undershooting the bank's target.
With the Canadian dollar sliding again, we're likely to see more of this over the next year or more. For anyone trying to understand what consumer prices are really doing in Canada, and how they relate to the Bank of Canada's inflation-targeting mandate, it's going to be confusing. At times, the explanations are going to sound like rationalizations burgeoning on smoke and mirrors.
What's important to remember is that inflation was chosen as a policy guide not because consumer prices themselves are so critical, but because inflation is a reliable proxy, over time, for capacity pressures. Yes, low and stable prices matter for guiding public expectations and instilling confidence for anyone making spending decisions, especially the kind of big ones that propel economic growth.
But in the shorter term of making specific interest-rate decisions, the bank is really looking at inflation to tell it whether the economy is overheating, i.e. running out of capacity to meet rising demand, or is underperforming, i.e. swimming in excess capacity far above demand.
In essence, the Bank of Canada's true guide is the output gap – the difference between the economic capacity being used and the economy's full potential. The bank said in its MPR that it figures the economy has anywhere from 1.25 per cent to 2.25 per cent excess capacity – which would have to shrink, through faster-than-normal economic growth, in order to bring the economy back to full steam and create the kind of meaningful inflation pressures that the bank would worry about.
Still, the big question is whether, by slicing up inflation so many ways in an attempt to filter out the noise, the Bank of Canada is getting this right. Not everyone agrees that the pressures in the core rate are as transitory as the central bank keeps telling us – and, by extension, whether the economy is really as cool as the bank thinks.
"The breadth of the [price] gains – with several key categories that have cumulative weights of nearly half the total CPI basket up by 2.2 per cent to 3.7 per cent year over year – dismisses a narrow emphasis upon supposedly transitory drivers," wrote Bank of Nova Scotia economist Derek Holt in a research note after Friday's inflation report.
"We are not changing our conviction that the BoC is facing a rising inflation threat that will soon come to increasingly question why it is cutting [interest rates] in this environment."