The recovery from the pandemic-induced recession has created the toughest and most important test yet for the Bank of Canada’s core inflation gauges. They’re not exactly acing it.
With the debate raging over whether Canada’s rising inflation rate (3.6 per cent in May) is a growing risk or a soon-to-pass tempest of temporary pandemic-related hiccups, the central bank’s three preferred measures of core inflation should be clarifying what truly reflects underlying inflationary pressures. Instead, they are adding layers to the haze.
Depending on which of the three gauges you look at, core inflation in May was either a smouldering 2.7 per cent (CPI-trim), a middling 2.4 per cent (CPI-median) or a tame 1.8 per cent (CPI-common). The range among those readings is the widest in more than a decade.
This almost certainly wasn’t what the Bank of Canada had in mind four years ago when it decided to drop its old gauge of core inflation, CPIX, which excluded the eight historically most volatile components of the consumer price index (CPI), in favour of the triumvirate of new tools. CPI-trim, CPI-median and CPI-common were carefully designed to do a better job of filtering out the transitory noise in the overall data and show us the true inflationary pressures underneath. And by applying three different lenses, the view into core inflation was supposed to get that much clearer.
Instead, the central bank has been trying to understand the sharp divergence among its core inflation measures during the pandemic and assess their usefulness. It devoted a special box in April’s quarterly Monetary Policy Report to the topic, a sure sign of how seriously it takes the problem. The bank acknowledged that the measures were susceptible to distortions brought on by the unique and sudden nature of the pandemic.
One thing that’s clear, when you look back at their historical movements, is that they are particularly out of sync when the economy is rebounding from a significant contraction or outright recession. Major divergences among the core readings can be seen in the early stages of the recovery following the Great Recession of 2008-2009 and the oil shock of 2015.
Regardless of the reasons behind this phenomenon, that’s particularly problematic for the central bank: Having a good handle on underlying inflationary pressures is critical to the timing of monetary policy tightening during the recovery phase. In the current context, the bank has had little choice but to look beyond its three preferred measures in assessing core inflation.
“Given the unique shifts in demand and supply and the resulting price movements caused by the pandemic and related containment measures, alternative measures of core inflation may provide additional useful insights into the assessment of underlying inflation,” the bank said in the April report.
On that front, Bank of Nova Scotia published a paper last week suggesting that the central bank’s past quest for more sophisticated core-inflation measures may have been misguided. Scotiabank’s research found that a simple measure of CPI excluding food, energy and indirect taxes – an old standby of the core-inflation biz – does a better job of revealing underlying inflationary pressures than the Bank of Canada’s three preferred gauges do, both individually and in combination.
(Incidentally, CPI inflation excluding food and energy was 2.4 per cent in May, up from 1.8 per cent in April.)
“Given our results, we think that the Bank of Canada should consider focusing its attention to the CPI excluding food, energy and the effect of indirect taxes and, to a lesser extent, to the CPI-common to evaluate the level of fundamental inflation pressures,” the Scotiabank report concluded. It noted that, not only has this measure been “significantly better” than the central bank’s favoured gauges at forecasting total inflation over the past four years, but its simplicity makes it “easier to communicate and analyze by markets.”
Scotiabank added that it intends to rely on this measure in its own macroeconomic model from now on.
It’s certainly food for thought. The Bank of Canada has often argued that a key reason for its use of an inflation target of 2 per cent to guide monetary policy is that it’s straightforward, highly visible (the data is published every month) and easy to understand. Simpler core measures offer these same virtues. Maybe the bank’s core inflation toolkit, which isn’t working so well right now anyway, could benefit from a bit of dumbing down.
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