The old lion of central banking himself, former Federal Reserve Board governor Paul Volcker, roared in a speech last April for central bankers worldwide to return to their main mandate of price stability. As if on cue, inflation has become a focus for financial markets and central bankers alike of late. This time, however, it is the lack of inflation which is keeping central bankers, and investors, up at night.
Canadian real return bond investors be on alert. While the goal of central bankers around the globe will be to return inflation to target, recent research shows Canada’s inflation path may take a much more circuitous route than investors currently appreciate. That route may entail an even more leisurely policy rate path and a notable period of above-target inflation prints than currently priced into fixed income markets.
By almost any inflation measure the Bank of Canada considers, inflation has been weak since the 2008 financial crisis. Over the past five years, total consumer price index (CPI) inflation has clocked in at just 1.3 per cent, a full 70 basis points below the bank’s 2-per-cent policy target; core inflation has averaged just 1.6 per cent. The other two core CPI measures that the central bank scrutinize also remain weak, with CPIW (a measure adjusted for volatility and the effect of tax changes) averaging 1.7 per cent in the past five years (1.5 per cent in the most recent three years) and CPI excluding food, energy and indirect taxes averaging just 1.1 per cent.
Just how is the bank going to deal with these weak inflation trends? On the surface at least, the Bank of Canada’s job is more simply and clearly laid out than that of many central banks. The Bank of Canada Act mandates a goal of 2 per cent inflation, the mid-point of the 1-to-3-per-cent range the bank operates in for total CPI. Typically, the bank aims to return inflation to the 2-per-cent target over a period of six to eight quarters; in the case where flexibility is required, such as the current weak global economic environment, the bank prefers to focus on a medium-term horizon of either three to five years or five to seven years, depending on which bank official is proffering the definition of medium term.
Though this seems like a relatively simple policy goal, the reality of Canadian inflation is much more complex. Indeed, a 2008 International Monetary Fund working paper found that even though the Bank of Canada targets inflation, i.e. the growth in prices, the behaviour of inflation since the mid-1990s actually bears more resemblance to price level path targeting (PLPT) – in which a period of below-trend inflation is made up for by a period of above-trend inflation, restoring prices to their original “path.”
The IMF authors speculate that “inflation expectations and [policy] interest rates are determined in a way that is consistent with an element of PLPT,” and as such, “bygones are not completely bygones” when it comes to the bank’s policy action as inflation deviates from target.
Headline inflation has closely followed a 2-per-cent trend line since the bank first started targeting 2 per cent as monetary policy goal at the end of 1995. Just a few years into the 2-per-cent inflation mandate, prices ran for a considerable period below this trend. To close the gap, inflation had to run well above 2 per cent for the next several years, with headline CPI averaging 2.6 per cent from 2000 to 2003.
A similar gap opened in 2008. Prices dipped well below the trend line as the Great Recession struck, and a gap between trend and actual CPI has persisted ever since. In fact, incorporating the Bank of Canada’s latest CPI forecasts in the chart shows that the gap is expected to persist into 2015.
There are two implications for investors. First, according to the IMF study, getting prices back up to trend will require a lower policy rate. For every 1 per cent deviation of prices from trend expected two years in the future, the policy rate should be about 37 basis points lower than a standard monetary policy rule would imply. Since the price gap is currently 2 per cent, that means policy rates could rise by 74 basis points less what is currently priced into the market. Second, if inflation is set to run considerably above 2 per cent for the next few years, the market’s inflation break-evens are much too narrow currently at 1.9 per cent, and real return bonds should be expected to outperform nominal bonds by at least 30 to 40 basis points.
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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