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Low inflation raises questions about rate cut

A weaker-than-expected report on inflation in Canada adds to evidence of an ongoing tug of war between economic growth and the hobbling effects of record household debt. The winner of this contest will determine the country's economic future.

The top line consumer price index rose by 0.7 per cent in October. Coming in only slightly below economists' forecasts, the figure is hardly a reason to panic or to gird for a tsunami of Japanese-style deflation. And core CPI, the Bank of Canada's preferred measure of inflation, came in as expected at 1.2 per cent.

The post-crisis trend, however, is sufficiently disconcerting that RBC Dominion Securities head of FIC strategy Mark Chandler titled his CPI chart "If it keeps on raining, the levee's going to break." Digging deeper into the components of the index, Mr. Chandler notes that only 20 per cent of the basket is showing price growth above two per cent, making this month's report "the largest breadth of disinflation in a decade." Top-line CPI is now three full percentage points lower than the post-crisis peak in June of 2011.

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The economic growth outlook remains solid, however, which may be a sign that fears of a deflationary spiral are overdone. Third quarter gross domestic product will be announced next Friday and a robust result of 2.5 per cent is expected.

The combination of strong growth and disinflation presents a policy dilemma for the Bank of Canada. A continuation in the downward path will soon push CPI below the one per cent level where the central bank's mandate would require it to cut interest rates.

At the same time, the Bank of Canada remains concerned about the record levels of domestic household debt. A cut in interest rates would motivate more borrowing and indebtedness, making the inevitable deleveraging process longer and more painful.

Retail sales data – the first place we'd expect to see the household debt overhang weighing heavily on consumers – remain strong. The most recent report from Statistics Canada showed year over year retail sales growth at 3.6 per cent, the highest level to date for 2013.

Scotia Economics vice president Derek Holt believes Canadians are addressing their debt levels, and that the Bank of Canada has plenty of scope to cut rates. "Clearly the issue [of household debt] has addressed itself and then some as household debt growth has ground to its slowest [rate] since the moribund 1990s," he writes. "I maintain there is too low of a probability of rate cuts priced into the short end of the Canada [yield] curve."

In the short term, there seems little reason to worry about a deflationary spiral and a lost decade of anaemic economic growth, or to learn Japanese. There are few signs of broader economic weakness and the Bank of Canada appears to have the flexibility to deal with disinflation through rate cuts if it becomes necessary.

Canadian household debt and the related issue of a potential housing bubble do loom over the mid-term economic outlook, however. The OECD and Capital Economics are only two of the observers predicting a severe correction in housing prices, and a multi-year period where consumer spending slows as debt is repaid. The real danger in today's report is that it may be another worrying sign that the Canadian consumer is tapped out.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More


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