The Bank of Canada stuck to the status quo last week, leaving its target for the overnight interest rate at 25 basis points and maintaining quantitative easing (QE) at a rate of at least $4 billion of bond purchases per week. But it did so in the context of higher inflation and a stronger-than-expected economy. With good news on the vaccination front and the prospect of more economic activity in the near term, there is reasonable concern the recent rise in inflation is more than just a one-off rebound from depressed prices a year ago. The Bank’s challenge now is to manage, not just inflation, but inflation expectations, as well.
Year-over-year headline inflation increased from 0.7 per cent in December to 1.0 per cent in January, just at the bottom of the Bank’s target range of one to three per cent. Two measures of core inflation (“CPI-trim” and “CPI-median”) have climbed to 2.0 per cent, though the “CPI-common” measure weakened slightly from 1.5 to 1.3 per cent. Real economic growth in the fourth quarter of 2020 was a stronger-than-expected 2.3 per cent (or 9.6 per cent at an annualized rate), and the Bank is now projecting further growth this quarter rather than the contraction it forecast at its last announcement in January. Ten-year bond yields have risen from 0.79 per cent on January 27 to 1.54 per cent on March 15.
The increase in inflation, combined with fears of more following massive fiscal stimulus both at home and south of the border, has investors worried about potential bond selloffs and, as a result, increasing yields. The Bank now has to try to keep inflation from accelerating in a way that puts pressure on the two per cent target and also manage the public’s inflation expectations.
Inflation itself may be higher than we think, understating the true cost of living. Statistics Canada updates its CPI consumption basket weightings once every two years to adjust, at a lag, for changes in consumers’ spending patterns. But the pandemic has played havoc with these patterns. People are spending much more on items like food, whose price has substantially increased, and much less on things like transportation that have experienced deflation (though oil prices have started to rise of late). Statistics Canada and the Bank have together addressed this problem by creating an “adjusted price index” that tries to get a better handle on these shifts in pandemic spending. Not surprisingly, from March through November, inflation using the adjusted CPI readings was higher than inflation using total CPI — by as much as 0.44 percentage points in November and by about 0.28 percentage points on average.
The big challenge on the inflation expectations front pits the size of the promised stimulus — big — against the economy’s potential output coming out of the pandemic — possibly smaller, because of “scarring” in the labour market and continuing COVID concerns. If the combined effect of the two is more money chasing even fewer goods and services, inflation will come sooner, a worry that currently underpins the higher yields we see in financial markets. While there is evidence that at the longest maturities investors remain confident the Bank will hit its two per cent target, increased yields at shorter maturities might slow down some of the stimulus boost from QE.
Any concerns over the accuracy of inflation readings will only exacerbate the problem of rising interest rates. The returns to securities of different duration embed a risk premium that depends on uncertainty about future inflation rates. Uncertainty about whether inflation is being measured accurately can only raise these risks and increase the yields.
The Bank of Canada has been very transparent throughout the pandemic. But it faces important communications challenges. Among the complexities it will have to explain are: “base-year” effects – jumps in inflation due to abnormally depressed prices a year ago — and why they might be temporary; how its purchases of government bonds will evolve; and the nature and importance of biases in the inflation measures during the pandemic.
If the Bank can help the public understand these issues more clearly, that should lead to more reliable predictions of, and reduced uncertainty about, future inflation. That will encourage firms to invest and consumers to spend and so help strengthen the recovery from the pandemic recession. More light will be a benefit to all.
Steve Ambler, a professor of economics at the Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, where Jeremy Kronick is associate director of research.