Why is Inflation still Under Wraps? A World Tour

04/02/2013 by Alex Carrick

Canada’s overall inflation rate in February accelerated to +1.2% from a quite low +0.5% the month before, according to Statistics Canada.

The “core” rate of change, which omits highly volatile items from the Consumer Price Index (CPI), was +1.4%. That was slightly ahead of January’s +1.0% advance.

The comparable numbers for the U.S. in February are easy to remember. Both the all-items CPI and the core rate were +2.0%. In other words, they were exactly on target.

Energy and food items are dropped in the calculation of the core rate of inflation. In the latest month, Canada’s energy sub-index was +2.0% year over year, while the U.S. figure was +2.3%.

In the important gasoline category, the price at the pump in Canada was +3.9%, which was slightly higher than in the U.S., +3.3%.

As for food prices, in Canada they were +1.9% and in the U.S., +1.6%.

An overall inflation figure of +2.0% or less is nothing to get excited about. It also poses a bit of a mystery for policy makers and analysts.

Economic history has shown that whenever there are large increases in the money supply, a ratcheting up of the general price level has been all but inevitable. Central bankers have certainly been pumping out the “lucre” of late. So what’s different this time?

Almost every other economic indicator has been shifting in another direction.

First, there’s been de-leveraging – in credit markets, consumer debt and government spending. 

The financial crisis of 2009 has led to a change in the capitalization rules governing banks. They are being required to hold more reserves. This has been cutting into the volume of private sector borrowing around the world.

Lending is gradually easing, but it’s still a long slow process. There is one positive trend to watch for. The improvement in U.S. house prices will once again lead to the issuance of more home equity loans.

Many individuals and families have been striving to reduce their debts. This has been most evident in the U.S. Under the admonishments of Finance Minister Flaherty, it’s also been taking hold in Canada as well.

But that’s only part of the story. Aging baby boomers, seeing retirement on the horizon, are socking away money. The savings rate is on the rise. (The first baby boomers, born just after the Second World War, are now reaching the previously normal job-exit age of 65.)

Governments nearly everywhere are facing the prospect of older populations. Anticipating rising health costs, they’re reining in spending now. The emphasis in recent budgets has been on austerity and paying down debt.

There are several corollaries to the foregoing. Many nations are also dealing with a declining population base. And even if they’re not, the dependency ratio is climbing. In other words, there are fewer “worker bees” relative to the old and the young.

Corporations have been sitting on cash. This has been a survival tactic, since the business outlook has been so precarious over the past several years.

Major firms in high-tech have been among the prime culprits. Some have been making huge profits. They say they’re building war chests to finance acquisitions, but so far their most apparent approach has been caution.

Setting loose funds for investment in new production facilities has been even more of a tough sell.  

There are also demand-supply and currency-value forces at work.

Commodity prices (with the exception of lumber) have fallen back from their peaks. Due to weaker global economic growth, the demand for raw materials has softened.

Almost all commodities are priced in U.S. dollars. When the value of the greenback falls, commodity producers – based around the world – often raise their prices in order to maintain their revenue streams.

The template for such a response to a falling U.S. dollar was originally set by OPEC.

In the early to mid-00s, a falling U.S. dollar was common. Since the recession, however, the opposite has been the case. In fact, given the financial turmoil during the past several years, investors have often sought shelter in U.S. treasuries, thus raising the value of the greenback.

The four primary currencies that are traded internationally are the U.S. dollar, the Euro, the Japanese yen and the U.K. pound. These are the currencies that make up the bulk of the foreign reserves held by governments around the world.

(As an interesting aside, the International Monetary Fund is studying whether the Canadian and Australian dollars should be added to the “sanctioned” list. To be considered worthy of inclusion, a currency should be both widely traded and free from government manipulation.)

The U.S. dollar is continuing to compare favorably with its chief rivals. Ongoing debt problems in Europe keep depressing the value of the Euro.

The Japanese government is taking deliberate steps to stimulate its economy through an aggressive monetary stance. One “side effect” (probably deliberate) is to lower the value of the yen, thus violating one of the IMF’s aforementioned rules.

The U.K. is flirting with a triple-dip recession. Enough said about the pound sterling.  

So where are the “hot spots” for inflation at this time? The most notable “burn zone” is in Venezuela (+22.8%). The prolonged fatal illness of Hugo Chavez has left that nation’s economy without a firm hand for too long.

Egypt (+8.3%), Turkey (+7.0%) and South Africa (+5.9%) are struggling to contain their price levels. They’re also three emerging countries with exceptional long-term prospects.

But it’s in the BRIC nations – the newly emerging powerhouses - where the performance of prices may stand out the most. India (+10.9%) is BRIC’s inflation leader, followed by Russia (+7.0%) and Brazil (+6.3%).

China (+3.2%), if its inflation number is to be believed, is doing best within the BRIC grouping, but Beijing is still worried and taking steps to curb the problem.

Average Chinese citizens are being most affected by rapidly rising home prices.
Canada inflation – all items CPI vs CORE*
(not seasonally adjusted)
Canada  inflation – all items CPI vs CORE
In Canada, the February 2013 year-over-year change in the energy sub-component index was +2.0% year. Gasoline was +3.9%.

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 February 2013 year-over-year change in the energy sub-component index was +2.3% year. Gasoline was +3.3%.

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.