Jump in core inflation fuels interest-rate speculation

Share

The "core" rate of Canadian inflation has unexpectedly jumped above the Bank of Canada's 2-per-cent target for the first time in more than two years, stirring debate about whether building inflationary pressures will shorten the calendar for eventual interest rate hikes.

Canada's overall inflation rate held steady at 2.1 per cent in August, Statistics Canada said Friday. But the core rate, which excludes the most volatile components of the consumer price index such as fuels and certain food staples, unexpectedly surged to 2.1 per cent from 1.7 per cent in July. It was core inflation's highest level since April, 2012, and well above economists' consensus expectations of 1.8 per cent.

Most major components of CPI rose in August, but those gains were offset by declines in fuel and food prices. Total CPI was unchanged in the month compared with July, but core CPI was up 0.5 per cent month over month. The jump in the core rate stemmed primarily from higher prices for passenger vehicles and telephone services.

"The surprisingly big acceleration in core CPI blows the Bank of Canada's third-quarter forecast for a 1.7-per-cent average out of the water, with something around 2 per cent more likely," said Bank of Montreal senior economist Benjamin Reitzes in a research note. "Given the broad nature of the gains, it might be tough for the [central] bank to argue the increases are transitory, and a continued upward trend will be difficult to overlook."

The Bank of Canada relies on the core rate as its key guide for the economy's underlying inflationary trend. The central bank adjusts interest rates with a goal of maintaining inflation near the 2-per-cent target, which is considered a good proxy for healthy and sustainable economic growth; in general, it would raise interest rates to cool the economy if inflation began running persistently above the 2-per-cent target.

Yet, even as inflation rose from less than 1 per cent late last year to 2.4 per cent by June, the Bank of Canada has maintained that the upward pressures were largely temporary, fuelled by a spike in energy prices and the after-effects of last year's declines in the Canadian dollar. The central bank has signalled that rate increases are likely at least a year away. But some observers have suggested that Canada's accelerating economic growth in recent months and the strong improvement in demand for Canadian exports might be creating more lasting inflationary pressures earlier than the central bank expected.

Friday's numbers both intensified and muddied the debate. In the interest-rate-sensitive foreign exchange market, the Canadian dollar spiked three-quarters of a cent against its U.S. counterpart within minutes after the release of the inflation report, on speculation that rising core inflation might press the central bank to raise interest rates sooner. The loonie gave back almost all those gains as the day progressed and traders felt August's big jump in core inflation may have been a freak event.

"Obviously, something was a bit funky," said Ian Pollick, senior fixed income strategist at RBC Dominion Securities. He noted that much of the core measure's surge stemmed from a big jump in household communications costs, which showed an outsized 8.9 per cent year-over-year gain. This may reflect an administrative adjustment in telecom providers' rates, one that won't be repeated in future months.

David Madani, chief Canada economist for Capital Economics, said the absence of the falling food and energy prices in the core rate exaggerated the impact of the higher communications costs.

"Over all, with underlying inflationary pressures still fairly subdued and the economic outlook still in doubt, we doubt that this latest inflation report will change the [central] bank's neutral view on the direction of interest rates," he said.

But Mr. Pollick observed that inflation is starting to appear across a widening swath of the economy, with now nearly half of the components of the core index running above 2 per cent. Meanwhile, upside surprises from month to month are becoming more common, keeping investors guessing on how much weight to place on each new CPI number.

"The bigger trend the market is trying to figure out is that there are a growing number of these 'transitory' one-offs," he said. "The noise-to-signal ratio is becoming louder."