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Next up for Bank of Canada: the dreaded spectre of deflation

Incoming Bank of Canada governor Stephen Poloz

CHRIS WATTIE/REUTERS

Was Mark Carney's love-in with the Canadian economy premature?

In his farewell speech last week as Bank of Canada Governor before moving to the Bank of England, Mr. Carney declared "Canada is working" and pointed with pride to the bank's success in keeping inflation anchored around the 2 per cent range, which allowed it to be the only G7 central bank not to engage in quantitative easing after the credit crisis. We wish Mr. Carney well in his new gig, but it may be premature to bronze his legacy just yet.

In fact, Canada may face a bigger risk than inflation: the dreaded spectre of deflation. As a result, Canada's next central banker, Stephen Poloz, may have to take further measures to stimulate the economy before he can tighten monetary policy.

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That's the assessment of economics research firm Capital Economics, based on troubling trends it sees in the data. In its most recent report on Canada, published last week, Capital Economics pointed out that inflation has fallen well below the target range of 1 per cent to 3 per cent and seems headed toward zero – or below.

Key factors dragging down prices are excess supply in the economy and competitive pressures in the retail sector. In addition, one of the biggest components of the consumer price index is house price inflation, which Capital Economics points out has "seen a substantial slowing." If that measure declines even moderately to negative 1 per cent from its present level of 1 per cent in the next year, it would "erase over 0.5 percentage points from underlying inflation."

That's soft-landing territory. But we also have a deteriorating global economy, lower commodity prices and, Capital Economics expects, a domestic housing downturn "which has only just begun." If house prices do indeed decline further, and other factors continue to be a drag, "we think it is plausible that underlying inflation could eventually turn negative."

Negative inflation, or deflation, is a troubling condition where incomes fall and relative debt burdens rise. Continuing price declines can lead to lower production and wages, in turn dragging down demand and prices. The longer deflation continues, the worse the effect.

Even the bears at Capital Economics aren't warning of a sustained period of falling prices. However, they caution that "a mild bout of deflation is now a real possibility." That is, unless there is "additional policy stimulus" – something that we imagine could take the form of asset purchases like the U.S. Federal Reserve has undertaken or some other unconventional approach, since there's little left to cut from interest rates.

Central banks did an admirable job saving the world from economic ruin, but we're far from out of the woods yet, as last week's events in Japan and the U.S. showed. Canada has looked good up to now, but for the country to keep working, some unexpected and unconventional tinkering by the Bank of Canada may be required.

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