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By HaleStewart July 24, 2014 8:24 am
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Bank of Canada Succesfully Argues That Inflation Spike Is Temporary

In its latest monetary policy report, the central bank of Canada notes that inflation has increased over the last few months.

Total CPI inflation has moved up to around the 2 per cent target in recent months. Core inflation has also increased, but remains below 2 per cent  Although the Bank had anticipated in the April Report that higher consumer energy prices and exchange rate pass-through would exert temporary upward pressure on inflation, the increase occurred sooner and has been larger than anticipated. The higher-than-expected inflation readings primarily reflect larger increases in energy prices, which are notoriously volatile, as well as other sector-specific factors that have temporarily affected core inflation.

This chart highlights the increase:

The long-term Canadian CPI series is very interesting, as shown in this chart:

Until 2000, there was a strong correlation between core (all prices less food and energy) and overall CPI (which includes food and energy).  The general belief in the economic community is that, in general, commodity prices should be removed from CPI calculations because they are not only volatile, but subject to corrections after strong increases, thereby making the price spikes transitory.  Central banks become concerned when commodity prices "bleed" into the core CPI – a situation which existed in Canada until 2000.  As the next graph shows, core and total CPI in Canada have diverged:

The dotted blue line represents total CPI, which has clearly had several episodes of higher year over year growth than core CPI.  This indicates that overall Canadian inflation is behaving far more “traditionally” than in the past, adding credence to the Central Bank's observation.

There is a strong belief that overall inflation will return to lower levels.  The report notes:

For example, tight supply conditions in North America have caused meat prices to soar.5 In addition, there has been a rapid rise in electricity rates (included in the core measure). While there is obviously some uncertainty and there may be some upside risk to the near-term path, the Bank does not expect the recent momentum in monthly inflation to persist.

To bolster their argument, the report contains this graph:

The graph places inflation components on a 4-quadrant graph that breaks their inflation contribution down into more or less persistant (horizontal) and if the data point is more or less important in its impact on inflation (vertical). The farther the reading is away from the center horizontal line, the more or less persistent its impact on inflation.  The farther a data point is from the vertical "0" line, the more or less pontential impact it has.  While the data points cited in the report are important (they can effect inflation in a more pronounced manner) the specific data points that are currently contributing to the spike in inflation (meat, electricity, clothing  and cars) have a minimal effect on inflation in the long term.

Only time will tell whether the Bank of Canada is right.  But they certainly have done a good job of analyzing the situation and providing a strong data case to back up their point.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer 

 

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