Just released data for March 2008 shows that inflation in the U.S. is running at a rate about three times as fast as in Canada − +4.0% year over year for the U.S. Consumer Price Index (CPI) versus +1.4% in Canada. Core inflation, which ignores products with high price volatility (e.g., food and energy), is more restrained in both countries (+2.4% in the U.S. and +1.3% in Canada). However, as consumers, we do have to eat and we do have to burn fuel, in some form or another.

The most dramatic price increases in both countries are energy-related. For example, the price of gasoline has risen by about one-quarter year over year in the U.S. and by nearly 10% in Canada. However, even numbers as recent as March have become out of date. The world price of oil has reached a new record high in April ($114 US per barrel) and this will put more upward pressure on the general price level in next month’s CPI reports.

In broad economic terms, the most important question is what impact present and anticipated price inflation will have on interest rate policy. Monetary authorities have a stated goal to control inflation through adjusting interest rates. In times of economic slowdown, however, providing economic stimulus through lower rates often takes precedence.

The U.S. Federal Reserve Board’s next fixed announcement date (FAD) with respect to interest rate policy is April 30th. The federal funds rate currently stands at 2.25%, down from a high of 5.25% less than a year ago.

The Fed has already applied a lot of stimulus, in various forms, to the U.S. economy. The limited progress in beating back the inflationary fires presents a serious problem. The federal funds rate may be chopped by another 25 basis points (100 basis points = 1.00%), but it is hard to envisage cuts beyond that.

Alan Greenspan (now retired) has found his record as Governor of the Fed under assault for holding the benchmark rate at only 1.00% for almost a year in late 2003 and early 2004. Some experts are arguing that this led to excessive risk taking in financial markets that culminated in the subprime mortgage collapse.

The Bank of Canada (BOC) next meets on April 22nd. The current level of the target overnight rate is 3.50%, down from a high of only 4.50%. Canada’s success in keeping inflation under wraps gives the BOC unusual freedom to adjust interest rates downward. The BOC will likely consider applying more stimulus to dampen the knock-on effects of the U.S. slowdown.

Plus the BOC also has to make an estimation of what the Fed is likely to do eight days later − the wider the gap between higher Canadian interest rates and lower U.S. interest rates, the greater the upward pressure on the value of the Canadian dollar. Canada’s export-dependent manufacturing sector has suffered enough due to the 60%-plus currency appreciation since early 2003. A 50-basis-point cut in Canada’s target overnight rate would be neither unexpected nor unwelcome.

(See also related Market Insights story with charts.)

Alex Carrick

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