In the intense discussion about the fast-evolving interest rate policy at North America's central banks, somewhat lost in all the intrigue has been the critical role of inflation. The trend in consumer prices could still prove the pivotal factor in rate decisions on both sides of the Canada-United States border – and we'll get an update on the numbers for both countries at a key policy juncture this week.
On Wednesday, the U.S. consumer price index for July will be released, just weeks before a crucial Federal Reserve Board meeting at which the U.S. central bank may finally begin the long-awaited raising of its interest rates.
Economic signals have increasingly supported this rate "lift-off," as it has been coined, but stubbornly low inflation has remained the big inconsistent stumbling block to the Fed pressing the launch button.
Meanwhile, Canada's July consumer price index is slated for release on Friday – and it will likely look unusually hot for a central bank that has been cutting interest rates, not raising them.
Economists expect Canada's year-over-year inflation rate to come in at about 1.4 per cent for July, a significant bounce from June's 1-per-cent reading but well below the central bank's 2-per-cent target that serves as its official guide for interest rate policy. However, the so-called "core" inflation rate, which excludes the eight most volatile components of CPI and which the central bank has long depended on as its primary guide for the underlying inflation trend, is expected to rise to 2.5 per cent in July – which would be its highest rate in eight years and its 12th successive month above the 2-per-cent target.
One economic blogger recently noted that the Bank of Canada had never before cut interest rates during any similar streak of above-target core inflation; normally, above-target inflation implies that the central bank should be considering rate increases. But this year, with the oil shock triggering a contraction in Canada's economy in the first half of the year, the bank has cut rates twice, most recently in mid-July.
The central bank has argued repeatedly that core inflation has been propped up by temporary factors, most notably the deep declines in the Canadian dollar, that don't reflect true underlying inflation in an economy that likely moved further away from its full capacity in the first several months of 2015. Indeed, the central bank has looked at a variety of alternative inflation measures to estimate that true underlying inflation is more like 1.5 to 1.7 per cent.
Still, the core inflation numbers create a communications and optics issue for the Bank of Canada, as the discrepancy between its policy direction and the inflation numbers lingers. The big question is whether the persistently high core inflation readings really are as transitory as the central bank keeps insisting – a question that will only get louder should the core rate rise again for July.
On the other hand, the United States is expected to post an inflation rate of a puny 0.2 per cent for July, up only slightly from 0.1 per cent in June. The U.S. core rate, which excludes the volatile food and energy components, is seen at 1.8 per cent, unchanged from June.
Unlike the Bank of Canada, the Fed has no official inflation target dictating its rate policy. However, the Fed's formal mandate is to seek out both maximum employment and price stability, and on the price-stability side, it has long talked about 2 per cent as its general inflation goal – and that goal remains elusive.
Indeed, the U.S. inflation picture has been at odds with otherwise strong evidence of a brisk acceleration in the U.S. economy and a dramatic tightening of the labour market. Job creation, crucial to the Fed's policy mandate, has totalled nearly three million over the past 12 months, or an average of nearly 240,000 a month; after a brief slowdown early this year, job growth has rebounded to an average of 235,000 a month over the past three months. The unemployment rate has fallen to 5.3 per cent, a seven-year low. Meanwhile, the U.S. economy grew at an estimated 2.3 per cent annualized rate in the second quarter, up sharply from a near-flat first quarter, and is expected to continue accelerating to something closer to a 3-per-cent pace in the third quarter.
That has the Fed inching toward a rate hike at least by the end of this year, and quite possibly sooner. But while some handicappers are betting that the first hike will come in September, others view the lack of inflation traction as a compelling reason for caution.
One thing observers will be looking for is evidence that the upward pressure on wages stemming from all that job growth is starting to be passed through to consumer prices in a significant way. Average weekly earnings were up 2.4 per cent year over year in July, and jumped 0.5 per cent in July alone, indications that tightening labour markets are both pushing up employers' labour costs and strengthening consumers' buying power. That will inevitably push inflation higher.
But powerful forces such as slumping commodity prices, especially in the energy sector, and the continued rise of the U.S. dollar are dampening consumer prices. Last week's Chinese currency devaluation triggered another round of commodity price declines and U.S.-dollar buying, potentially deepening the downward pressures keeping U.S. inflation at bay. If the July inflation report comes in below expectations, the prospect of continued below-target inflation could convince the Fed to sit on its hands until clearer evidence of price pressures emerge, later in the year or even into early 2016.