Will the Bank of Canada’s next move be a cut in interest rates? That outcome depends largely on whether the economy is experiencing a shock to demand or a shock to supply. Evidence indicates the latter, which is doubtless why the central bank has chosen to wait and see – and why no rate cuts will be necessary.
The Bank of Canada’s latest quarterly Monetary Policy Report (MPR), published last week, painted a quite optimistic outlook for the global and domestic economy. Its U.S. gross domestic product (GDP) growth forecast was bumped up, as expected, to a respectable 3 per cent for 2014, and Canadian GDP growth received a 0.2-percentage-point bump to 2.5 per cent.
Despite this brighter growth outlook, the bank severely downgraded its outlook for inflation, based largely on the weaker-than-expected inflation numbers seen since the last MPR in October. Indeed, the bank expects inflation to remain below its 2-per-cent target until the end of 2015, at which point almost four years of below-target performance (in the core consumer price index, or CPI) will have been recorded. To put this into perspective, according to the Inflation Control Framework backgrounder on the Bank of Canada’s website, the bank usually returns inflation to the 2-per-cent target within six to eight quarters; the longest ever recorded, until now, was 11 quarters.
To understand what the current disinflation means for monetary policy, it is helpful to break apart the standard inflation model and consider separately the drivers of inflation that make it up: slack in the economy, inflation expectations, supply factors and the error term.
The bank continues to argue that weak economic conditions are an important factor of disinflation. But evidence suggests that economic slack can explain, at most, 30 per cent of disinflation over the past two years. In fact, it may have had virtually no impact.
The Bank of Canada’s measure of the output gap indicates about 1 per cent more spare capacity in the economy than it had two years ago, and the unemployment rate, at about 7.2 per cent, has been essentially unchanged. Both core and headline CPI declined about one percentage point over the same two-year time horizon.
An assumed 6- to 6.5-per-cent neutral unemployment rate range would suggest labour market slack is 0.7 to 1.2 percentage points. To back-out the impact on inflation requires an estimate of the “sacrifice ratio” – the required gap between the actual unemployment rate and the neutral unemployment rate to bring inflation down by one percentage point. Standard models put the sacrifice ratio at about 4 for Canada – although current persistently high unemployment suggests it could be considerably higher.
Even assuming a modest sacrifice ratio of 4, that suggests that slack economic conditions account for about 0.18 to 0.5 percentage points of disinflation (i.e. excess unemployment of 0.7, divided by the sacrifice ratio of 4, is 0.18 percentage points; 1.2 divided by 4 is 0.3 percentage points). These rather generous assumptions indicate that weak economic conditions account for about 20 to 30 per cent of the one-percentage-point decline in inflation since early 2012.
As to inflation expectations, most of the survey measures and market-based metrics the Bank of Canada tracks suggest expectations fall around the 2-per-cent target. As I discussed in a previous contribution to Economy Lab, consumer-type inflation expectations may have shifted lower, and the reason for that decline may be correlated to the recent drop in commodity prices.
In fact, evidence suggests that the vast majority of recent disinflation is the result of various supply shocks, which can result from changes in productivity growth, commodity prices, the exchange rate, and changes in the competitive environment. The central bank puts particular stress on the impact of the last of these, particularly on core inflation in the food and non-food goods price categories.
Regardless of the source, from a monetary policy standpoint, the key thing to consider about supply shocks, and their impact on inflation, is whether the shock is permanent or temporary. Temporary changes in supply are easy for monetary policy makers: Just ignore them. A plunge in gasoline prices that lasts for just a quarter or two will not meaningfully change consumer behaviour – households will just pocket the windfall and allow savings to rise for a time.
Permanent supply shocks are much trickier. For example, the oil price shock in the early 1970s resulted in a shift in relative prices over many years, rising unemployment, and a sharp slowdown in economic growth. To some extent, these long-lasting changes in supply required a more accommodative monetary policy. Getting the degree of accommodation right proved the difficult part; too-easy monetary policy boosted inflation expectations for many years to follow.
The supply shocks currently driving inflation lower appear to be temporary, albeit more persistent than most analysts expected. Thus the bank is correct in letting them run their course through the retail market. However, as Bank of Canada Governor Stephen Poloz noted last week, the longer these temporary factors persist, the greater the risk that businesses and consumers start planning with lower inflation targets in mind – and thus longer-term inflation expectations decline below the bank’s 2-per-cent target. In such an event, a cut in interest rates may become necessary.
One final supply shock well worth noting is the recent plunge in the Canadian dollar, which has fallen by about 15 per cent since mid-2011 and shows no sign of levelling off. This may soon emerge as an important counterforce to the supply conditions currently suppressing consumer inflation.
The “error term” is the last driver of inflation worth considering. Despite its name, it is not included in a model to account for mistakes. It captures all other elements of the inflation process not accounted for in the other components of the model, including uncertainty, changes in consumer or business behaviour, etc. However, the bank’s dispersion metrics produced in the MPR suggest the error term has not increased over the past couple of years, so thankfully, this murky aspect of inflation does not need to occupy us at this time. It does, however, bear watching.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.