Canada's latest surprise inflation surge is surely a wake-up call to the Bank of Canada. Governor Stephen Poloz's nagging concerns about the risk of disinflation are now stretching the bounds of plausibility; his message on the inflation front will surely have to change, lest the bank strain its credibility with an increasingly skeptical financial market.
Statistics Canada reported Friday that Canada's CPI rose 2.3 per cent on a year-over-year basis in May, up from 2.0 per cent in April and well above economists' expectations. Inflation has now accelerated from less than 1 per cent last fall, to a number that is conspicuously above the bank's own policy target of 2 per cent – the legally entrenched inflation level to which the central bank is supposed to adjust its official interest rate to achieve (typically, higher interest rates to cool inflation when it trends above that level, lower rates when it trends below).
As CPI has gained momentum this year, Mr. Poloz has insisted that it is being driven by transitory factors, specifically the fallout from a sharp drop in the Canadian dollar ("exchange rate pass-through" in Bank of Canada parlance) and a surge in energy prices. And, indeed, May's inflation rise was fuelled significantly by the energy component, which was up 8.4 per cent from a year earlier.
But if you exclude energy prices, May's CPI is still up 1.7 per cent year-over-year, a sharp increase from April's 1.4 per cent. Likewise, the central bank's so-called "core" inflation measure – which excludes the most volatile components of CPI, particularly food and energy – was also 1.7 per cent in May, up from 1.4 per cent in April.
Meanwhile, one has to wonder how long "exchange-rate pass-through" should be expected to distort the inflation trend. The Canadian dollar did fall more than 10 cents against its U.S. counterpart in the span of a year – but for the past five months the currency has actually been stable, in the 90 to 92 cents (U.S.) range. Certainly it would take a while for last year's decline in the loonie to work its way fully through pricing for imported goods (and goods dependent on imported inputs), but presumably the impact should already be softening in the month-to-month numbers as the currency continues to hold its footing. Yet on a month-to-month basis, core CPI was up 0.5 per cent (unadjusted for seasonal effects) in May, in a month when the dollar actually rose.
Since core CPI is the rate that, in practice, the bank focuses on as its main rate-policy guide, it still has a fair bit of wiggle room before 2 per cent arrives. But the rate of the core's acceleration should be attracting the bank's full and undivided attention; as recently as February, it was a mere 1.1 per cent. The whole point of the core CPI measure is that it is indicative of broader inflationary pressures beyond passing fluctuations in fickle things like gasoline prices and currency blips; this is precisely why the bank focuses on it.
And notably, core inflation (like the overall CPI) has now far surpassed the Bank of Canada's most recent forecasts contained in its April Monetary Policy Report. The bank predicted that core CPI growth would average 1.2 per cent in the current quarter, and wouldn't reach 1.7 per cent until a year from now.
Clearly, the market is convinced that the Bank of Canada is going to have to re-write its outlook, and, by extension, its interest-rate policy. The Canadian dollar spiked more than a half-cent against its U.S. counterpart immediately after the news, to 92.99 cents (U.S.), its highest level in more than five months, as traders salivated over the prospect of an earlier arrival of higher interest rates from the central bank. Canadian government bond yields were also higher across the board, with the five-year benchmark climbing more than 7 basis points, its biggest rise in three months.
In the face of the numbers, and the market's interpretation, Mr. Poloz is going to have a very hard time justifying sticking to the status quo in mid-July, when the Bank of Canada issues its next rate-policy statement as well as a new Monetary Policy Report. Certainly the forecasts are going to need some serious adjustments. And if the bank has any feel for the public and market mood, it is going to want to spill considerable ink explaining, in detail, its analysis of inflationary pressures, and whether it still believes the rising inflation pace, now having spilled over into its core measure in a big way, is still a passing phase.
Anything short of that, and the market may well take it as confirmation of long-standing suspicions that Mr. Poloz's disinflation theme was merely a ploy to talk down the Canadian dollar. If its message is going to remain credible, the bank really must acknowledge that inflation now has a significant upside risk.