Inflation has once again gone outside the bounds of the Bank of Canada's 1- to 3-per-cent target, falling to an annualized rate of 0.8 per cent. This comes on the heels of Mark Carney's admission that economic growth and inflation are much slower than they had anticipated a few months ago.
Economic forecasting is incredibly difficult, with so many factors influencing the rate at which an economy grows and the rate of inflation. There are a number of economic indicators that a forecaster can use to predict the movement of the economy. The most notable of these is the yield curve, which is the difference in interest rates on bonds of different maturity lengths. For the past nine months, the yield curve has been screaming that the economy was slowing down. Yet the Bank of Canada chose not to listen.
The relationship between the yield curve and inflation expectations is well known in economics. A 1987 paper from the Kansas City Fed defines the relationship as follows: "The view that the yield curve is an indicator of inflation expectations has a basis in economic theory. Inflation expectations influence the shape of the yield curve by affecting expected short term interest rates. When investors revise their expectations about long-term future inflation rates upward, theory predicts the yield curve will steepen."
In other words, when the gap between a long-term and short-term interest rate rises, inflation is on the way. If the gap narrows, expect inflation to fall.
This view is shared by the Bank of Canada's own research. A 2010 Bank of Canada study by Fung and Remolona concluded: "In this paper, we construct a … model to estimate inflation expectations and inflation-risk premiums in Canada and the United States using bond yields of 2-, 5-, and 10-year maturities. The results suggest that there is useful and substantial information that can be extracted from the yield curve."
Following the Bank of Canada's advice, I examined the difference between the yields on 2-year and 5-year government bonds, using data provided by the Bank of Canada. The data used is from the period where the target for the overnight rate was 1 per cent (from October, 2010, to today); I limit the data to this period so the yield curve is not being affected by monetary policy.
The results are striking (click here to view the chart). The gap between the 2- and 5-year bond yields rises until March, 2011, where the gap peaks at 94 points. The gap steadily falls to a 35 point difference by the end of 2011. After holding steady for a few months, it drops sharply between March, and May, 2012, losing 18 of 38 points.
By the Bank of Canada's own research, such a quick, substantial drop in the yield curve suggests the market is expecting a slowdown in inflation and economic growth. Yet after considering national and international factors, the bank's July 2012 Monetary Policy Report ends with the sentence: "Overall, the bank judges that the risks to the inflation outlook in Canada are roughly balanced over the projection period."
I wish the Bank of Canada would explain why it held a neutral stance in mid-2012 when the yield curve, as defined by the bank's own research, was forecasting disinflation.