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June 14, 2021

On Wednesday, the Bank of Canada left its target for the overnight rate at 0.25 per cent, and kept its purchases of Government of Canada bonds at $3-billion per week. Forecasters and financial market participants expected these announcements, and took them in stride. Below the calm surface, though, a couple of key questions about Canadian monetary policy are causing concern.

One is about where inflation is going. The year-over-year increase in the consumer price index (CPI) hit 3.4 per cent in April, its highest reading in a decade, and above the 1- to 3 -per-cent acceptable range the central bank has for its 2-per-cent target. The bank’s statement on Wednesday emphasized that such above-target CPI increases are temporary. When demand for many items fell off a cliff in March and April of last year, so did their prices. So in March and April of this year, comparisons with a year earlier exaggerated the trend in inflation – a “base effect” that will be with us for a while, but will eventually fade.

Some indicators, however, are less reassuring. Some of the bank’s own “core” inflation measures, which strip out volatile CPI components such as gasoline and food, are also running above 2 per cent. The bank highlights six on its website: CPI-trim, CPI-median, CPI-common, CPIX, CPI-XFET and CPIW. Each has its advantages and disadvantages, but each is meant to get at inflation’s underlying trend, discounting short-term volatility. Hence, the bank can better set monetary policy with an eye toward the medium-term horizon of six to eight quarters, at which point the bank expects inflation to be at the 2-per-cent target.

Four of the six core measures were above the 2-per-cent target in April, including CPI-trim and CPI-median, which are two of the three core measures (along with CPI-common) that the bank introduced in 2017 and has favoured since.

While year-over-year changes are the ones that get most attention, changes over shorter intervals can give clues about what is coming next. The bank and Statistics Canada do not publish monthly values for these newer core indexes, but a recent piece by the National Bank does this for us. What they find is an annualized rate of change at a three-month seasonally adjusted interval of 2.7 per cent for CPI-median, and 3 per cent for CPI-trim. This would suggest there is underlying momentum to inflation beyond simply volatility and base effects.

The reason for that momentum brings us to the other key question: how the Bank of Canada is dealing with the enormous increase in federal government spending since last spring. Federal income supports exceeded the income lost during the pandemic: the household saving rate in the second quarter a year ago was 27.4 per cent, the highest on record, despite the largest quarterly fall in GDP since the Great Depression. Even as the economy began to recover in the third quarter, the savings rate remained elevated (13.5 per cent), higher than any time since 1993. It was 13.1 per cent in the first quarter of 2021. Chartered bank deposits as a share of the economy have never been higher. While there are groups who have been disproportionately hurt by the pandemic, there is plenty of pent-up demand. With governments extending income supports, remaining slack in the economy may disappear faster than the Bank of Canada’s announcement suggests.

The fact that the federal government is financing its spending by borrowing, and that the Bank of Canada is buying such large quantities of federal government bonds, naturally raises questions about the interaction of monetary and fiscal policy. There is more to the federal government’s deficit than bond-market borrowing, and there is more to the bank of Canada’s balance sheet than federal bonds – including the fact that it pays interest on the reserves it creates to pay for these bond purchases, thereby reducing the size of any surplus it can transfer back to the government. But it is a troubling coincidence that the bank’s $3-billion-a-week pace of purchases adds up, over 52 weeks, to almost exactly the $155-billion deficit projected for this fiscal year in the federal government’s recent budget.

An increase in the overnight rate sooner than suggested in the bank’s announcement Wednesday is a possibility. And further reductions in the pace of bond purchases would be a positive sign.While we have no doubt the bank has the tools to deal with inflationary pressures, there is reason to worry that the recent rise in inflation is more than just temporary

Steve Ambler is professor of economics at the Université du Québec à Montréal (Retired) and the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, where Jeremy Kronick is associate director, research and William B.P. Robson is CEO.

Published in the Globe and Mail