Friday's double whammy of key economic data from Statistics Canada – retail sales and inflation – raises an interesting prospect for the Bank of Canada: Its rate policy may become a victim of its own success.
Statscan reported that February retail sales climbed a solid 0.4 per cent from January, despite a slump in the cost of gasoline that sapped overall retail prices. On a volume basis, sales were up a strong 1.5 per cent.
At the same time, March's consumer price index inflation came in at 1.3 per cent year over year – down a shade from February's 1.4 per cent, but still higher than economists had expected, given the massive 14-per-cent decline in gasoline prices from a year earlier. The core measure of inflation – which strips out eight volatile components of the CPI, most notably gasoline, in order to get a better picture of underlying inflation pressures – jumped to 2.1 per cent from 1.9 per cent.
Both were considerable surprises. Retail sales had been widely expected to take a step backward in the month, after a supersized 2-per-cent gain in January, especially given that most other key economic indicators had stumbled badly in February from a white-hot start to the year. Core inflation was expected to be a much more tame 1.7 per cent.
The Canadian dollar leaped nearly a half-cent against the U.S. dollar within minutes of the news, and why not? The retail sales numbers put economic growth back on track for a strong first quarter – perhaps north of 3 per cent annualized. And core inflation jumped the central bank's 2-per-cent target, putting it in territory where an inflation-targeting central bank would typically start contemplating whether a rate increase would be appropriate to cool the price pressures.
The data underlined that the momentum in the Canadian consumer sector is a driving force in the country's growth recovery, even as many other parts of the economy remain fitfully mixed. Retail sales have risen in eight of the past 10 months, and their momentum appears to have accelerated markedly in early 2016. In the first two months of the year, retail sales volumes (seasonally adjusted) surged 3.6 per cent.
The blistering pace may now be fuelling consumer inflation to heights where the central bank will have to start taking notice. And yet it was the Bank of Canada itself that provided the vital fuel that is driving the consumer surge.
The Bank of Canada's two interest rate cuts last year were intended to stimulate the country's oil-shocked economy, but it takes months for rate cuts to work their way into the economic fabric. Only now are the stimulative effects becoming palpable.
Nor were their effects going to be equal across all contributors to the economic recovery. Canadian rate cuts aren't going to stimulate capital spending in the energy sector, where acutely low commodity prices have obliterated the business case for those investments. And while they do help to drive down the Canadian dollar, making our exports more competitive, there's nothing they can do about sporadic demand in those export markets – something that remains an issue.
But what they do particularly well is keep the foot on the gas of consumer spending. The pace of household credit growth has actually increased in the past year, even as incomes have slumped badly in resource-heavy regions. Dirt-cheap interest rates are helping keep the consumer sector buoyant, and are underpinning demand in the housing sector. Which is kind of what the Bank of Canada had in mind when it made the rate cuts in the first place.
So the rate cuts are working their magic on the consumer – maybe, from the Bank of Canada's perspective, a little too well.
The central bank believes the economy needs sustained growth in non-resource exports to get properly back up to full speed; that export growth will, in turn, fuel investment in business expansion and increased hiring, which will generate a virtuous circle of income, spending and growth.
But if booming consumer spending is going to fire up inflation to the point where the currency markets start contemplating Bank of Canada rate increases, a key support for export growth – the dollar – gets pulled out from beneath the whole recovery structure. That has already started; the dollar topped 79 cents (U.S.) this week, a nine-month high, and it gains a little more strength with every statistic that suggests the Canadian economy is growing faster than expected.
Expect the bank to address this by sticking with its long-standing position that core inflation is overstating underlying inflationary pressures, that it has been distorted by "transitory" factors, most notably the previous sharp declines in the Canadian dollar. It may also play down consumer spending as having gotten ahead of itself, while expressing greater concern about the uncertain momentum in exports and business investment. This could cool speculation in the currency about an earlier-than-expected rate rise.
But as the influence of the 2015 rate cuts continues to get stronger as 2016 progresses – something the bank itself fully expects – the consumer momentum could prove resilient. Ultimately, the question will be at what point will that might push inflation to the bank's breaking point.