Poloz Faces Core Inflation Conundrum as Standing Pat Gets Harder

  • Bank of Canada decision Wednesday comes amid robust data
  • Core measures and rates have’t moved in tandem since 2010

The Bank of Canada will almost certainly keep its benchmark interest rate unchanged at 0.5 percent in its decision Wednesday, but with recent data suggesting the economy is on fire, explaining why is getting trickier.

Analysts expect policy makers will highlight the softness in underlying price pressures as evidence of the kind of lingering slack that would justify the current degree of monetary accommodation. Be warned: in the past, they’ve shown a willingness to look through these numbers before moving on rates.

Stephen Poloz

Photographer: David Kawai/Bloomberg

The core measure the central bank used from 2001 through 2016 -- CPIX, which excluded volatile elements like food and energy prices -- has proven to be a poor guide to its policy rate changes over the past seven years. And its new preferred gauges -- while superior -- aren’t stellar in this regard, either.

If market-watchers were asked to estimate the direction of the Bank’s policy rate based solely on CPIX, they’d likely have been wrong in all cases. In 2010, the central bank was hiking rates as core inflation decelerated below 2 percent, then cutting in 2015 with this indicator north of 2 percent.

“Core inflation is not that finely aligned with the output gap and how it’s doing,” said Douglas Porter, chief economist at the Bank of Montreal. “It’s not shocking that some measures of core have come down; it’s a lagging indicator, so it does make sense that it has ebbed.”

Porter said there’s a reasonable case to be made for Bank of Canada Governor Stephen Poloz to hike rates this week, though he wouldn’t recommend such a course because it would likely shock markets. Bank of Montreal projects the bank will stand pat.

It’s little wonder the bank elected to switch focus late last year to three different measures of underlying price pressures when renewing its inflation control-target with the government. CPI trimmed mean, CPI weighted median, and CPI common component all do a better job of filtering out the kind of sector-specific shocks that don’t give the central bank insight into how pricing pressures are evolving broadly, a key defect of the old exclusionary measure.

All are also generally trending downwards, with the common core index running at its lowest level in more than 20 years.

How the Bank of Canada explains the downward trend in this trio will be an essential element of Wednesday’s rate decision and Monetary Policy Report, due at 10 a.m. in Ottawa, and the press conference at 11:15 a.m. Its language on this subject will provide insight into whether policy makers are getting closer to laying the foundation for a future rate increase -- or at the very least, ditching their easing bias.

“If they dismiss it as the result of temporary factors, that will be a more hawkish signal," said Frances Donald, senior economist at Manulife Asset Management. “However, in my view, it’s more likely that they emphasize that weak inflation is an ongoing repercussion of the large output gap in Canada. That should be interpreted as ‘hold’ language and potentially even dovish.”

These gauges share one flaw with the old focal metric: they tell us more about where the economy’s been than where it’s at, or where it’s going.

The three new measures have their strongest relationship with the output gap -- which tracks excess capacity or a lack thereof -- with roughly a four-quarter lag, the central bank’s January Monetary Policy Report showed. Changes in monetary policy take a fair amount of time to filter through the economy. As such, using current readings of core inflation to justify a given policy stance is like using speed signs in a residential neighborhood as a guide to how fast a car should be going on the highway.

The recent trends in core inflation don’t mesh with readings on activity. Canada saw above-potential growth in the second half of 2016, and @NowcastCanada estimates that first-quarter growth is tracking an annualized 4.2 percent pace. Economic data has been on a tear, with headline job growth surprising to the upside for eight consecutive readings -- the longest such streak since 2009.

Randall Bartlett, chief economist at the Institute of Fiscal Studies and Democracy, expects these core inflation measures to catch up in the second half of 2017, in light of how quickly the economy has been reducing its excess capacity recently. But in the meantime, he expects the bank to repeat its message about the elusive rebalancing of growth towards exports and business investment and the relatively muted readings on pricing pressures.

"For the Bank under Stephen Poloz, the indicators focused on in the Monetary Policy Report are those that support the narrative the governor would like to put out there," said Bartlett. "So this time, it’ll be the core measures and the drag from net exports in the first quarter of the year."

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