Forex Investment and Currency Trading

Inflation fixation
This week saw a firmer-than-expected CPI report that served to cast some doubt on whether Canada can remain an “island” of low inflation. April’s monthly, seasonally-adjusted increase in the CPI of 0.4% (headline and core) heightened concerns that inflation may be percolating. To be sure, the nation’s inflation rate remains very subdued on an annual basis. With readings of 1.7% in the headline measure and 1.5% in the BoC’s core measure, inflation is still comfortably below the 2% target and below the readings in most other major industrialized countries outside of Japan. However, a handful of transitory factors – the strong CAD appreciation through the final three quarters of 2007, a 1pp cut in the federal Goods & Services Tax (GST) rate in January 2008 and heavy retail competition – have arguably made the year-ago inflation rate look a little better than warranted. Indeed, even prior to the release of this week’s report, BoC Governor Carney suggested underlying inflation was running closer to 2.0% than 1.5% at the end of Q1. The same conclusion may be drawn from the three-month annualized trend for core inflation, which has jumped to 2.4%.

Food for thought
Going forward, food price inflation might continue to exert pressures – both headline and core. The impact on headline prices is obvious (food prices were up 0.6% on an adjusted basis in April). However, core prices can also be affected, both through broader input cost pressures and a factor unique to Canada – the construction of the BoC’s core inflation measure. The core measure (CPIX8) excludes indirect taxes and eight historically volatile components – led by most energy components outside of electricity, but only a few food components. Specifically, only fruit & vegetables are excluded (representing 2.3% of the CPI basket), whereas the U.S. core inflation measure excludes all food components (13.8% of the CPI basket). Thus, if “ag-flation” remains a dominant theme, Canada will see more of the impact in its core inflation measure. Note that Canadian CPI excluding food and energy is currently running at 1.1%, some 0.4pp below the BoC’s CPIX8 measure.

Keeping it on target
While the BoC’s measure of core inflation may be better than some (or most), it is important to note that it is an “operational guide” rather than the target itself (headline inflation). Over the past decade, headline inflation has outstripped core inflation by 0.4pp on average, but run just 0.15pp above its 2% target rate. Relating this to the article on inflation targeting, one can say that the BoC has been successful within the narrow scope of an inflation targeting central bank. A question that the BoC is now struggling with is whether an inflation target itself is appropriate or whether they should be adopting a more stringent price-level target. Even small, cumulative errors in targeting inflation can lead to significant losses in purchasing power. In Canada’s case, the 0.15pp average “miss” has left the level of prices some 2.3% higher than it would otherwise have been over the past decade. If a price-level target were in place, then periods of above-target headline inflation would have to be offset by a period of extended below-target inflation. The desirability and effectiveness of a price-level target is currently under examination at the Bank of Canada ahead of the renewal of their inflation targets in 2011. To date, the Bank’s research has suggested at least some theoretical support for such a target. There are many factors that would have to be considered ahead of time, including: which index to target; the appropriate time period over which the target should be set (the BoC’s inflation control target has been set for a period of five years most recently); and, whether it makes sense for a small, open economy subject to terms of trade shocks to attempt to do this alone.