How low will Canadian inflation go? Perhaps too low for comfort

Written By Unknown on Minggu, 16 Maret 2014 | 22.40

Does Canada still have a too-low inflation problem?

The recent upward drift in the consumer price index, which the Bank of Canada watches like a hawk, appeared to put to rest concerns that the country was headed for disinflation, a period of low and declining inflation.

But it appears the relief may have been premature.

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Despite a recent upward drift in the consumer price index, Canada may still be headed for a period of declining inflation.

This Friday's inflation reading for February is likely to again grab central banker Stephen Poloz's full attention, with some economists predicting the Statistics Canada report will show the annual CPI falling below one per cent, and even as low as 0.5 per cent, from January's comfortable 1.5 per cent setting.

That will put inflation, or lack of it, back on the central bank's radar in time for next month's quarterly monetary policy report and possibly elicit more fretting from Poloz that the lack of price pressure suggests the economy's output gap continues to grow, or at least is not closing as fast as it should.

The central bank had been breathing easier of late after the economy's healthy 2.7 and 2.9 per cent jumps in output in the final two quarters of 2013.

But early indicators are that growth has fallen back again — partly due to an unusually bitter winter — but also because the global picture continues to disappoint. CIBC recently downgraded its estimate of growth for 2014 to 2.1 per cent, four-tenths of a point behind the bank's.

"Very low inflation could be combined with the possibility that the Bank of Canada might have to revise upward its estimate of spare capacity (in the economy)," said Scotiabank Economics vice-president Derek Holt.

"That would continue the long pattern of pushed-out optimism on the output gap's closure and the return of inflation to the two per cent target."

The reason this is important is that the longer the bank feels it will take to return inflation to two per cent, the longer it is likely to keep interest rates low to push the economy in that direction. That's good news for borrowers, such as those wishing to buy a home, but its not so good for the economy generally, Holt says.

"Even soft inflation can influence consumers to hold off spending and business investment decisions," Holt says. "If business think prices for their end products are not going up or going lower, they will be less inclined to ramp up production."

Bank of Montreal chief economist Doug Porter is also projecting a weak inflation number for February, although he thinks it will be in the order of one per cent, which currently is the consensus. That shouldn't worry the central bank overly, he says, even though it is below its target.

"If they could actually hold inflation at one per cent, I don't think the bank would be too uncomfortable with that," he said. "The concern is you are too close to deflation for comfort and if anything hit the economy, we could dip into the dreaded deflation territory."

The classic example in the modern era of deflation damaging the economy is Japan in the 1990s, where actual average price drops had the unwanted effect of convincing consumers to hold off buying decisions in order to take advantage of lower prices down the road, triggering a reinforcing cycle of lower economic activity and still lower inflation.

Canada is nowhere near that point, economists note. Canada's low inflation record of the past two years is almost certainly a symptom, rather than a cause, of both a weak domestic and external economy.

Even if Friday's CPI comes it at the low end of expectations, it will likely be an aberration due to what Jimmy Jean of Desjardins Capital Markets calls an "arithmetic quirk."

Inflation jumped through the roof February 2013, meaning Friday's reading will be based on that inflated base effect. On a month-to-month basis, it is known that gasoline prices rose as have utility costs.

Another reason to take a more benign view of inflation is that the Canadian dollar has lost about 10 per cent value over the last several months — with some lag, that depreciation should pump up import prices and heat up inflation across the economy.

Still, Holt said should Poloz take note of the low inflation phenomenon in next week's speech or next month's policy report, it could have a dampening impact on long-term interest rates, as well as place more drag on the low-flying loonie.

At the very least, the inflation report will reinforce the message that the bank is not even close to raising interest rates, agreed Porter.


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