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opinion

After a fair bit of research and deliberation, the Bank of Canada is pretty sure that inflation will still do what it is supposed to do in a growing economy – go up. It's just not so sure that it wants to bet any more interest-rate hikes on it until it sees the economic data to justify its faith.

In announcing on Wednesday that it had decided to hold steady on rates for the time being – on the heels of rate hikes in its previous two policy announcements – the BoC signalled it is very much in a wait-and-see mode for its next rate move.

While Governor Stephen Poloz made clear the bank still expects to raise rates further in the coming months as the economy continues to expand at a healthy clip, the bank said it will be "cautious" in its rate decisions from here. There are just too many things the bank's policy makers don't quite understand about how things will play out from here.

And at the top of that list is inflation. Inflation was the first item of discussion in the bank's rate-decision statement.

Inflation issues occupied not one but two special "boxes" in the Monetary Policy Report – one of the central bank's favoured devices to draw attention to the most pressing questions dominating its monetary-policy deliberations. At the same time, the bank released two staff analytical papers on factors affecting Canadian and global inflation.

That left no doubt the inflation riddle is a major preoccupation for the central bank's top decision makers. And that riddle, in a nutshell, is why do we still have remarkably tame inflation even as the Canadian economy has accelerated to more or less full speed?

That is, after all, the standard recipe for inflation. The two rate hikes over the summer were predicated on the widely accepted economic notion that inflation rises as an economy uses up its spare capacity. Indeed, after the country's economic surge of the first half of the year, the central bank now estimates the output gap – the difference between how much the economy is producing and how much it has capacity to produce – is essentially closed.

Yet, the inflation rate has only just started to pick up and remains well below the bank's 2-per-cent target, which serves as its formal guide for setting monetary policy. And even the recent increases are less than convincing; the modest climb to 1.6 per cent in September was helped considerably by a spike in gasoline prices due to hurricane-related U.S. refinery shutdowns – a textbook temporary distortion, the kind of thing the BoC usually looks past when assessing inflationary pressures.

This is hardly new; inflation has been stubbornly weak throughout the post-financial-crisis economic recovery, not just in Canada but throughout the world's advanced economies. Persistent economic weakness could usually be blamed. But the increasing worry in some quarters is that the inflation model is somehow broken, that the world has changed so much that one central bank's domestic monetary policy can't get inflation back up to where it used to be.

In economies such as Canada's that have overcome that persistent weakness and returned to full capacity, the moment of truth has arrived.

But the BoC's researchers examined the question and concluded that global factors often blamed for inflation's demise, such as globalization and digital technology, haven't had a big impact in Canada. The stubborn lag in inflation in Canada can still be attributed to good old-fashioned supply and demand, obscured by various transitory factors. (The latest of these is this year's rise in the Canadian dollar, which the bank believes will trim about 0.5 percentage points off year-over-year inflation by the middle of next year, after which its impact will drop off.)

"This work has generally confirmed our faith in our model of inflation, in which inflation depends mainly on the degree of excess demand or excess supply in the economy, and this process operates with a lag," Mr. Poloz said.

But the faith has yet to be proven. And to make things more complicated, the Bank of Canada isn't entirely sure if the economy is, in fact, running at full capacity. It believes that companies' facilities are essentially operating at their maximum output, but the labour market still has slack in it – as evidenced by the still relatively tame growth in wages. And businesses have stepped up their investing as the economy has surged this year, implying that capacity is being added to meet rising demand. So the economy may still have more room to grow before the inflation train leaves the station.

So the bank has shifted into caution mode while it waits for economic data to justify its faith that the inflation model still works. In fact, Mr. Poloz said that as long as inflation remains below the 2-per-cent target, "we continue to be more preoccupied with the downside risks to inflation" – a pretty clear signal the next rate hike is going to need some evidence that inflation is taking hold.

The risk is that the central bank waits too long to be convinced it is right, that capacity pressures have triggered inflation. But by getting two rate hikes under its belt in the summer, the bank has hedged its bet on this front – tempering the economy and creating a headwind on inflation that will buy it some more time to see if the inflation-and-capacity forces beneath the surface are behaving as expected. Its hope is that it has done just enough to keep the risks balanced. It's a delicate dance the central bank has begun.