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Market misreading the runes on new inflation data

To hear the financial markets tell the story, Friday's higher-than-expected Canadian inflation numbers have ratcheted up the chances that the Bank of Canada will change its tune and start raising interest rates sooner than it has been suggesting. Don't be fooled. The central bank still has plenty of wiggle room before the rising inflation tide is going to swamp its resolve.

Statistics Canada's consumer price index report showed inflation running at 2.4 per cent year over year in June, the highest rate in 28 months. The so-called "core" inflation rate – which excludes some of the more volatile components, and is essentially the Bank of Canada's preferred gauge for the underlying inflationary trend – hit 1.8 per cent, a two-year high.

Both were higher than economists had expected, not to mention pushing the envelope on the Bank of Canada's own projections, which it updated just the day before. And the markets sure noticed: The loonie jumped four-10ths of a cent against its U.S. counterpart in the immediate aftermath of the inflation release, while Canadian government bond yields jumped higher.

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In at least one sense, the market's reaction is appropriate. As Bank of Canada Governor Stephen Poloz explained Wednesday in discussing the central bank's monetary policy report, the surprisingly strong upturn in inflation over the past few months has taken away much of the risk of falling inflation; a downturn when the inflation rate is hovering near 1 per cent, as is was a few months ago, is a much bigger threat to the economy than the same downturn when inflation is running moderately above the bank's 2-per-cent target.

So, seeing inflation creep still higher in June probably even further reduces the chances that the central bank's next move in interest rates would have to be a cut. And less of that downside risk is bullish for bonds and the dollar – though it must be said, the chances of a rate cut weren't that high anyway.

On the other hand, there's little here to suggest Mr. Poloz's thinking on inflation is wrong-headed. He still believes the recent surprising rise in inflation is due to transitory effects of price spikes in specific areas, such as energy and food (most notably meat), and still lacks the underlying economic strength to be sustained. And, indeed, the June numbers were driven strongly by higher food and energy costs; if you exclude both of these notoriously volatile and hard-to-predict segments from the mix, inflation was up a modest 1.6 per cent.

Over all, the numbers are not way out of line with expectations or how the bank sees inflation evolving. Mr. Poloz thinks inflation will drift lower again in the coming months, and there's nothing here that would cause him to change that.

But forget the Bank of Canada's expectations for a moment, as it's fair to say that not everyone agrees with them. Consider just the numbers – where inflation is now, and where the central bank targets it.

Yes, the inflation rate is above the bank's specific policy-guiding target of 2 per cent. But not talked about nearly enough lately is that the bank has always operated policy in a band around that number, from 1 per cent to 3 per cent. Think of this as the central bank's comfort zone, as well as its wiggle room; the whole purpose of this operating band for the inflationary target is to provide the bank with flexibility to wait for inflationary trends to play out for a while, to distinguish between transitory and more permanent pricing changes, before feeling compelled to adjust interest rates to steer inflation back toward the midpoint of the band.

At 2.4 per cent, the inflation rate is still closer to the midpoint sweet spot than the upper end of the comfort range. Just as the bank didn't start sounding worried about ultralow inflation until it started threatening the 1-per-cent bottom of the band, it's not going to fret about rising inflation until it starts to see 3 per cent closing in – especially given that it strongly believes the upturn won't last.

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As such, any thoughts among currency and bond traders that the June numbers have changed the rules of the game would be misplaced, or at very least wildly premature. The evidence from the June report more confirms what the central bank has been saying than refutes it.

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