Central bankers have no end to excuses as to why inflation has slowed so precipitously. They may be missing the most important one: A slump in consumer inflation expectations, and the role commodity prices play in shaping those expectations.
Disinflation – a decline in the rate of increase in inflation – has become a pressing concern for investors and policy makers alike, mainly because it raises real borrowing costs for businesses and consumers, and can lead to slower economic growth. Consumer price inflation has dropped well below the targets of most developed-market central banks in the past few quarters, even prompting the European Central Bank to unexpectedly cut policy rates this fall, and the Bank of Canada to switch to a downside bias in its communiqué last week.
Monetary policy makers have seemingly offered every reason, other than inflation expectations, for the disinflation outbreak. The Bank of Canada cites two main causes for the decline in core consumer price index (CPI) inflation, which has slumped to just 1.2 per cent in the latest report from 2.3 per cent in early 2012. In its Monetary Policy Report in October, the bank pointed a finger at substantial spare capacity and intense discounting at the retail level.
There’s reason to question both of these. The evidence of spare capacity in the economy is decidedly mixed. Corroborating this assertion, the bank’s own measure of the output gap suggests spare capacity is now 1.3 per cent of gross domestic product (GDP), up from virtually nil at the end of 2011. That’s not at recessionary levels, but it is in line with what was observed during the mid-cycle slowdowns in 1986, 1995 and 2003. Unit labour cost growth has slowed in tandem with CPI, suggesting that labour market pressures are very tame.
However, other capacity metrics tell an opposite story. Capacity utilization continues to rise and, at 81.7 per cent in the third quarter, sits less than on percentage point below the long-run average – which, when breached, would signal an overheating economy. The unemployment rate is at a five-year low of 6.9 per cent. A broader measure of labour market strength, the employment-to-population ratio, has been 61.8 per cent for the past two years – not high by historic standards, but not deteriorating, either.
The case for retail discounting seems plausible at first glance. Several new foreign discount stores have entered the Canadian retail market in the past couple of years, and large retailers frequently blame competition for poor quarterly earnings results. The problem, however, is that there has been no discernible change in inflation within that sector. In fact, the goods component of CPI, excluding energy and food purchased at stores, has been virtually flat for the past five years. Unless those foreign interlopers are offering cheap haircuts and babysitting services, the argument that they are a disruptive presence does not have weight.
So why is core inflation threatening to sink below the bottom of the Bank of Canada’s 1-to-3-per-cent target range?
The problem could be that consumer inflation expectations have declined. A recent study published in online policy research portal VOX by economists Olivier Coibion (University of Texas at Austin) and Yuriy Gorodnichenko (University of California, Berkeley) suggests that central bankers focus on the wrong measures of inflation expectations, such as the spread between nominal and real interest rates and the predictions of professional forecasters. These measures continue to suggest inflation expectations remain “well-anchored” (in Bank of Canada parlance) at the bank’s 2-per-cent inflation target.
Mr. Coibion and Mr. Gorodnichenko found that consumer measures of inflation expectations, such as the University of Michigan five-year inflation forecast from the monthly Consumer Sentiment Survey, do a much better job explaining U.S. CPI trends. And most importantly, these consumer-type inflation-expectation measures are not anchored at the U.S. Federal Reserve’s inflation target at all, but rather have a strong correlation with commodity prices such as energy and food. And the latter has dropped rather sharply of late.
This issue rings especially strongly in Canada, considering that energy and store-bought food make up 13.5 per cent of core CPI. Indeed, these components account for about 0.75 percentage points of the 1.16-percentage-point decline in core CPI since the February, 2012, peak. (This despite the common misconception that core CPI excludes food and energy; it does exclude some of the more volatile elements such as produce and gasoline, but it still contains the likes of meat, bread, dairy, fish and electricity.)
This issue puts the Bank of Canad at a disadvantage, since there are no direct measures of long-term consumer inflation expectations in Canada, but some research work on proxies for consumer price expectations could prove fruitful. It also suggests that disinflation concerns could swiftly shift to inflation worries should there be an upswing in the always-volatile commodity space.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.
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