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Inflation’s Okay for Now, Starting to Set Off Alarm Bells for Longer-term

03/26/2012 by Alex Carrick, RCD Canadian Chief Economist

In February, the year-over-year change in the Consumer Price Index in Canada was +2.6%, according to Statistics Canada. That was up from +2.5% in January and +2.3% in December.

The “core” rate of inflation, which omits eight highly volatile sub-categories, mainly in the food and energy areas, was +2.3%. That’s the highest the core rate of inflation has been since December 2008.

In the U.S., the all-items year-over-year change in the CPI was +2.9% in February, the same as in January. Exclusive of food and energy, the U.S. CPI change was +2.2%, down from +2.3% the month before.

That’s not the whole story on U.S. inflation, however. The Federal Reserve likes to monitor another series, the Personal Consumption Expenditures (PCE) price index excluding food and energy.

The PCE at +1.9% in the latest two months has been increasing at its fastest pace since November 2008.

The bottom line is that the nominal rates of inflation aren’t indicating a problem at this time. In the vicinity of +2.0% is considered to be okay by most central bankers.  

But there are reasons to worry about inflation longer term. And there are certain price movements within the product sub-categories that are nudging alarm bells on their own.

For example, the price of gasoline in February increased on a year-over-year basis in both Canada and the U.S.

In Canada, the year-over-year percentage change moved up to +8.9% from +6.8% the month before. In the U.S., it increased to +12.6% from +9.7%. (As an aside, those numbers are still nothing like the +28.5% rise in Canada and the +35.6% climb in the U.S. in June of last year.)

The U.S. economy is offering increasing evidence that recovery is solidly underway. Two million net new jobs have been created in the past year.

Still, there are persistent worries that the improvement may be derailed. What are the threats to the rosier outlook?

Much of the downside risk has focused on Europe’s debt problems and weaker growth in China, from the usual +10.0% for “real” (i.e., inflation-adjusted) GDP to +7.5%.

The more serious threat, however, may reside in gasoline prices that become prohibitively expensive.

There are two factors at play in world oil markets. Tepid global recovery or not, the growth in demand for oil is on the rise. Plus, there are too many flash points with elements of the Arab world.

Iran’s nuclear weapons aspirations remain in the forefront. But other incidents continue to crop up, such as the shootings in Toulouse, France, carried out by a self-styled jihadist.

In normal times, the inflation rate is the key variable that influences a central bank’s monetary policy. More recently, with most economies so fragile, the priority has been to establish firmer economic growth before all else.

This has caused the Federal Reserve and monetary authorities in other countries to set and maintain record low interest rates.

The Fed has said it will persevere with a federal funds rate in a range between 0.00% and 0.25% (i.e., in effect, zero percent in nominal terms and negative in “real” terms) until the end of 2014.

If the U.S. economy keeps adding jobs at a rate of 200,000 per month, this is going to become an increasingly contentious position.

When describing the recovery, the term “fragile” hasn’t been replaced by the word “robust” yet, but if and when that does occur, the ultra low interest rates will become harder to justify.

The history of monetary management is littered with examples in which interest rates were kept too low for too long and inflation insinuated its way into the economic fabric. It is extremely hard to stuff the inflation genie back in the bottle once it has been let out to frolic.

Wage demands chase price increases in a never-ending spiral. Considerable labour unrest is already in evidence, although in many cases having more to do with government austerity measures than the inflation rate.

Current examples of unhappy wage earners include ground crews at Air Canada, librarians and inside workers with the City of Toronto and school teachers in B.C.

There is also another matter that is of concern to inflation watchers. Over the past several years, there have been excessively large increases to the money supply.  

The Fed has instituted two stages of monetary easing, QE1 and QE2, and there continues to be speculation that a QE3 may be on the way.

At present, a lot of the excess money is simply sitting in savings deposits. For example, corporations have been making large profits and hoarding the cash.

It will be a challenge to integrate the surplus money into the regular economy as conditions continue to improve and firms in the financial sector relax their credit-granting restrictions.

When money starts moving more normally again, the tendency to drive up prices will be greatly enhanced.

Certain prominent bankers – e.g., Federal Reserve Bank of St. Louis President, James Bullard – have been speaking out publicly about how important it will be for the Fed to have a proper exit strategy with respect to its current monetary policies.

The hardest task for monetary authorities is to pick turning points accurately. If not accomplished with aplomb this time around, elevated inflation that persists for many years may become our next plague.

Canada inflation – all items CPI vs CORE*
(not seasonally adjusted)
Canada  inflation – all items CPI vs CORE
In Canada, the change in the energy sub-component index was +7.2% year over year in February 2012.

The Canada figure (CPI) is the All Items Consumer Price Index. *Core inflation has been defined by the Bank of Canada. It is the Consumer Price Index (CPI) excluding the eight most volatile components: fruit, vegetables, gasoline, fuel oil, natural gas, intercity transportation, tobacco and mortgage interest costs. It also excludes the effect of changes in indirect taxes on remaining items. The core inflation rate in Canada is monitored with respect to setting interest rate policy. The target range is 1% to 3%.
Data source: Statistics Canada.
Chart: Reed Construction Data - CanaData.
U.S. inflation: all items (CPI-U) vs all items less food and energy
(not seasonally adjusted)
U.S. inflation: all items (CPI-U) vs all items less food and energy
In the U.S., the change in the energy sub-component index was +7.0% year over year in February 2012.

The U.S. figure (CPI-U) is the All Items Consumer Price Index for All Urban Consumers.
Data source: U.S. Bureau of Labor Statistics (Department of Labor).
Chart: Reed Construction Data - CanaData.


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