Is inflation dead or just sleeping?

10/12/2012 by John Clinkard

According to Statistics Canada, the headline (all items) inflation rate in Canada slowed to 1.2% y/y in August from 1.3% in July.

This was its second lowest point since November of 2010. This benign inflation picture was reinforced by a slowdown in the core rate of inflation* targeted by the Bank of Canada.

In August, it slowed from 1.7% to 1.6%, its lowest value since June of 2011 and significantly below the Bank’s 2% inflation target.

Given this below-two-percent value for the core inflation rate, the very muted pattern of headline inflation over the past several months, and several weak economic indicators, including existing house sales (-5.8% m/m), total exports (-3.4%) and manufacturing sales (-1.5% m/m), it appears very unlikely that the Bank of Canada will start to raise interest rates until the first quarter of 2013 at the earliest.

However, a closer look at the inflation data reveals that while pressure on the key components of both the headline and core CPI have eased over the past several months, this is a temporary phenomenon and both core and headline inflation will slowly gain momentum in the coming months.

First, following a steady slowing since May of 2011 the energy component of the CPI exhibited a modest increase in August reflecting the impact of a gradual rise in petroleum prices and a concomitant flattening of natural gas prices since mid year.

In addition, although headline food prices were little changed on a month-over-month basis in August, the core food price index, excluding fresh fruit and vegetables has moved steadily higher over the past two months primarily due to higher meat and bakery products. This has been partly on account of drought-induced increases in corn and wheat prices.

Also, sustained relatively strong growth of full-time employment over the past year should cause the shelter component of the core index to trend gradually higher over the near term.

Although the very near term outlook for inflation remains quite muted, there are a number of signs that this situation is temporary.

Late in 2012 or early in 2013, the combination of higher commodity prices and a gradual increase in demand should put upward pressure on both core and headline inflation.

This prospect suggests that inflation in Canada is definitely not dead but merely taking an extended nap.

* The Core CPI excludes eight of the Consumer Price Index’s most volatile price components including fresh fruit and vegetables, mortgage interest costs, natural gas, gasoline and tobacco products

Canada Inflation – Headline vs. Core

Canada Inflation – Headline vs. Core
Data source: Statistics Canada/Chart: Reed Construction Data, CanaData.