Title: Is inflation making a comeback?

Sub-title: Core inflation remains low in Canada. But there are signs that it could go much higher.

 

Last week the Bank of Canada surprised analysts by keeping its policy lending rate steady at 3.0 percent. Canada’s economy has been showing signs of weakness and many thought that a rate cut was in order. By signalling that interest rates ought to be lower, the central bank could easily have sparked a new round of borrowing and consumption that would have provided the economy a nice boost. So why didn’t it?

 

The problem is that the Bank of Canada maintains a steady balancing act between keeping the economy running smoothly and maintaining inflation under control.

 

That’s getting much harder now because a wide variety of inflationary pressures have emerged recently. These range from rising fuel and food prices, to slowing growth in outsourcing, rising transportation costs and loose monetary policy at many of the world’s major central banks. And as bad as these are, things could get worse. Much worse.

 

Inflation: is a good run coming to an end?

Canadians have had a good run on the inflation front for some time now. Prices for most goods and services we buy have increased only gradually for most of the past quarter century. In some sectors, such as imports from emerging nations, prices have even fallen.

 

As recently as the first quarter of 2008, core inflation in Canada was running at just 1.4 percent in real terms and total inflation was just 1.8 percent. But last week, the Bank of Canada raised its forecast for total CPI inflation by later this year to 3.0 percent.

 

According to Jeff Rubin and Benjamin Tal two economists at CIBC World Markets,  one of the reasons that inflation has been kept under control so well in Western countries, is that outsourcing by Western manufacturers and rising imports from low wage countries like China have kept price increases in line.

 

However those imports are now being threatened by rising fuel costs. “Higher energy prices are impacting transport costs at an unprecedented rate. So much so, that the cost of moving goods, not the cost of tariffs, is the largest barrier to global trade today,” write the two in a recent paper for the bank’s clients. “(These) exploding transportation costs are removing the single most important brake on inflation over the last decade – wage arbitrage with China.”

 

However rising transport costs are only one of several inflation pressures that the BoC is looking at. Two of the fastest growing world economies; China and India, are both giving significant signs of overheating right now. Rising food and oil prices are hitting hard in both those countries. That’s important because in a global economy, the effects of inflation and reactions to it, spill easily across borders.

 

Even the United States, the prime market for Canadian exports, is battling with inflation. Federal Reserve chairman Ben Bernanke, in an effort to help attenuate the effects of the sub-prime loan debacle, has flooded the economy with cash. Yet while so far those efforts look to be generating positive effects, this excess liquidity has pushed inflation numbers up there.

 

How inflation can spiral out of control

The big challenge to public policy makers is that when businesses see inflation rising elsewhere, they start raising prices for the stuff they sell too. Workers are no different. When their gas and food prices go up, at the next salary negotiations they ask their employers for more money. If not controlled, this can create a spiral, in which one round of inflation sparks another then another.

 

Inflation has been so low for so long, that many younger Canadians have never known how bad things can get. For example inflation was a real problem during the 1970s. Even by the early 1980s, after Bank of Canada had tightened consumption growth drastically by forcing major banks to boost mortgage and other key lending rates to more than 20 per cent, average inflation was still rising by close to 10 percent.

 

Scarred by the experience on the 1970s and 1980s, veteran public policy markets are keeping a close eye on things to make sure they don’t get back out of whack. Some developments they have little control over, like rising food and oil prices. However the Bank of Canada, by keeping its policy rate high, or even raising it if necessary, can to a large extent slow spending by Canadians, which in turn can help keep pricing pressures lower. 

 

That said, the most important thing to fear about inflation is….the fear of inflation itself. That’s why the Bank of Canada did not hesitate to keep its policy rate steady, by foregoing a policy rate cut, at a time when the economy is slowing.

 

Peter Diekmeyer (peter@peterdiekmeyer.com) is Bankrate.ca’s economics columnist.

 

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